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Fed Turns Hawkish on Fears of Higher Inflation

Posted: Tuesday, June 22nd, 2021

Estimated Reading Time: 3 minutes

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The Federal Reserve of the United States (Fed) took markets by surprise last week as it delivered a hawkish message. It shifted its tone swiftly, indicating two possible rate hikes in 2023. The market expected only one.

Naturally, the US dollar gained across the dashboard. It closed the week at its highs, and even the stock market indices corrected in reaction to the Fed’s decision and presser.

Yet, the stock market reversed most of its losses yesterday. It appears that the Fed’s message is either discounted by markets, or the Fed is not taken seriously.

The risk here is that the Fed will end up doing more, not less when it comes to tapering and removing the accommodative conditions. An even bigger hawkish surprise in the second half of the year is possible.

Hawkish Fed

Does the Fed intend to correct its message this week? Fed’s Powell is due to testify today in front of the House Select Subcommittee on the Coronavirus Crisis. Judging by the stock market’s reaction, investors are quite complacent with the last Fed’s message.

But what caused the Fed’s shift away from FAIT?

A Case for a More Hawkish Fed

The Fed runs a dual mandate – job creation and price stability. One year ago, during the Jackson Hole Symposium, the Fed announced the introduction of an Average Inflation Targeting (AIT) regime.

More precisely, it suggested that it will allow inflation to overshoot the original 2% target. By how much, the Fed did not mention, but it appears the threshold has been reached.

As such, progress in the labor market is the one thing to follow during the summer months. Seasonality turns supportive for the labor market in the months ahead, so there is room for optimism.

Fed Inflation

Moreover, the removal of the Fed UI benefits until September further supports the idea of a strong pickup in payroll growth. Sure enough, the road to full employment is long and bumpy, but progress in the labor market would push the Fed to a more hawkish stand.

2021 Jackson Hole Symposium and the Fed’s September Meeting

As the second quarter of the trading year comes close to an end, the focus shifts to what happens over the summer and beyond. Trading during the summer months tends to be slow, which should favor higher stock market prices.

In August, the Fed might use the Jackson Hole Symposium once again to outline its shift in policy. If we look at the trajectory of Core PCE, then the Fed is unlikely to ignore the progress in the labor market.

So the risk is that the Fed will turn even more hawkish at the Jackson Hole. And, that the September FOMC meeting would be very hawkish when compared to the June one.

At the September meeting, the forecast horizon will be extended to 2024, with the risk of revealing a steeper fed funds path. If that is the case, the US dollar should find bids on every pullback.

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