U.S. Economic Outlook

Insight into the Fed’s reaction function

The U.S. jobs machine is shifting up toward accelerating recovery. Not only have expectations for July been exceeded by a headline non-farm payroll figure of 943,000, but the revisions to the two previous months added another 119,000 jobs. Thanks to the pick-up in hiring, the unemployment rate declined to 5.4% in July from 5.6% in June. While this certainly is sound progress, it is still some way from what the Fed most likely judges as maximum employment, one of its primary monetary-policy goals. On August 4 the U.S. Federal Reserve (Fed) Vice-Chair, Richard Clarida, explained that an unemployment rate of 3.8% would be in line with his idea of maximum employment. This was the first time a high-ranking Fed official put a definitive number on the mysterious formulation of the Fed’s first goal.[1] And Clarida’s comments on the reaction function of the Fed are an important guide – he is a prominent academic contributor to modern macroeconomic thinking and the chief architect of the Fed’s new monetary framework.[2]

Besides maximum employment, the new framework envisages "…inflation moderately above 2% for some time so that inflation averages 2% over time" as a prerequisite to eventually increasing interest rates.[3] Economists, Fed-watchers and the rest of the investment community, long uncertain about what exactly the Fed had in mind when talking about average inflation, also got some other concrete answers from Clarida. He said, "Core PCE inflation since February 2020 … is running at 2.7% through June 2021 and is projected to remain above 2% in all three years of the projection window.” This, Clarida added, satisfies the "on track to moderately exceed 2% for some time" threshold specified in the statement.[1]

Clarida’s somewhat cryptic comments are eye-opening. Our take on his remarks is that so long as the annualized change in core PCE price inflation since February 2020 is somewhat above 2%, the Fed is willing to start increasing interest rates, further provided that the unemployment rate is down to 3.8% – which is expected by us sometime in late 2022 or early 2023.

But what about the feared overshooting of inflation? The Fed has also never quantified at what point they see inflation as too high. Again, Clarida has answers. If "…core PCE inflation this year does come in at, or certainly above, 3%, I will consider that much more than a 'moderate' overshoot of our 2% longer-run inflation objective."[1]

What remains not quite clear is the measure the Vice-Chair has in mind – year-on-year inflation or the average since February 2020? Our take given his remarks on the importance of the average inflation rate, is that should the average core PCE inflation rate remain above 3% at the beginning of 2022 the Fed will get nervous and most likely start to abandon the "transitory" element of their judgment on inflation. The most likely consequence would be a switch into a more aggressive mode to counter higher inflation and reduce the support for growth.

Our interpretation of Clarida's statements, however, combines with our inflation forecasts to suggest that the Fed will have enough room to remain quite complacent about inflation and to further support the expansion (see Chart). But we believe vigilance will be required should inflation prove more persistent than we expect and remain on or above 3% even on a year-on-year measure.

Annualized core PCE inflation since February 2020

202108_U.S. Economic Outlook_CHART_EN.png

Sources: Bureau of Economic Analysis, Haver Analytics, DWS Investment GmbH as of 8/10/21
Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect.

What must also be kept in mind is that the FOMC now consists of 18 participants and 11 voting members. And while it is safe to assume that the Vice-Chair's views have significant weight and are close to those of Fed Chair Jerome Powell, policy is made by the entire voting committee. His remarks therefore only give us a rough guidance on the FOMC's collective thinking. For now, however, and especially as other officials are more volatile and less straightforward in their public remarks, we see Clarida's words as an important prelude to Powell’s much anticipated remarks at Jackson Hole. Here we expect more insights – especially on the topic of tapering asset purchases, that we expect to be announced in September. From our perspective, the recent sound labor-market data, and on target inflation, should soon enable the Fed to declare "sufficient further progress" – the prerequisite for reducing its asset purchases.

Overview: key economic indicators

2021

 

 

 

2022

 

 

 

Q1

Q2

Q3F**

Q4F

Q1F

Q2F

Q3F

Q4F

GDP (% qoq, annualized)

6.3

6.5

7.4

7.0

4.5

3.2

3.6

4.5

Core inflation (% yoy)*

1.7

 

3.4

3.0

2.8

2.9

2.3

2.3

2.5

Headline inflation (% yoy)*

1.8

3.8

3.3

3.1

2.7

2.3

2.2

2.3

Unemployment rate (%) (EOP)

6.2

5.9

5.0

4.5

4.4

4.3

4.2

4.1

Fiscal balance (% of GDP) (EOP)

 

 

 

-16.4

 

 

 

-5.4

Federal funds rate (%)

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

0.0-0.25

*PCE Price Index    ** Forecast

Source: DWS Investment GmbH as of 8/10/21
Forecasts are not a reliable indicator of future returns. Forecasts are based on assumptions, estimates, views and hypothetical models or analyses, which might prove inaccurate or incorrect.

 

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