The Big Idea

Connecting the dots

| March 19, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

The Fed’s latest summary of economic projections and Chair Powell’s comments at his press conference start to sketch the Fed’s expectations for monetary policy over the next several years. Futures markets and economists’ projections point to a modestly faster path for liftoff. But even that may be too slow. Tapering looks likely to begin as early as October this year with the first Fed rate hike coming as early as spring 2022.

Setting the agenda

A projected timeline for Fed policy normalization starts with the order of events. For the most part, it appears the Fed would like to roughly follow the sequence from the last normalization cycle. That points to a probable series of steps:

  1. Talk about tapering
  2. Initiate tapering
  3. End asset purchases but maintain the size of the balance sheet
  4. Liftoff on the fed funds target rate
  5. Allow balance sheet runoff.

The only ambiguity here would be the order of the final two steps. In the prior cycle, the FOMC lifted off in December 2015 but did not begin shrinking the balance sheet until late 2017, after four fed funds hikes. In theory, the FOMC could decide to begin shrinking the balance sheet before lifting off in the current cycle, especially considering how large the balance sheet will be by the time it peaks. However, the order will probably be the same as last time. The FOMC in the 2010s expressed a strong preference to leave the balance sheet steady until it was sure the economy was out of the woods and a return to the zero bound looked unlikely any time soon.

Filling in FOMC preferences

The FOMC offered projections for its fed funds rate target in the dot estimates, but clues to the other four steps come from some of the statements from Powell and others on the committee. Official forward guidance says the Fed would need to see “substantial further progress” toward its dual mandate goals before beginning to curtail asset purchases. Powell emphasized at his press conference a need for actual rather than projected improvement.

Substantial further progress might mean something like narrowing half the employment gap from December 2020, when the guidance was introduced, to full employment, along with at a minimum significant movement toward 2% on the inflation front. That would imply an unemployment rate in the low 5%s or a cumulative rise of close to five million for payroll employment or both. But officials may be looking for even more strengthening than that, perhaps closing about 75% of the December 2020 gap. Inflation is going to be tougher to gauge because the Fed is already promising to ignore the short-term run-up in year-over-year inflation likely over the next three months to six months.

Judging from the FOMC’s latest economic projections, the median estimate of the unemployment rate for the fourth quarter of this year is 4.5%, which would be awfully close to the Fed’s estimate of full employment. But many Fed officials seem to believe labor force participation will recover more slowly than hiring and the unemployment rate will continue to understate the degree of slack in the labor market. On the inflation side, the FOMC looks for a temporary burst in prices to 2.4% by late this year followed by a moderation back to roughly the 2% target in 2022 and 2023.

It is also important to note that Powell and others at the Fed have talked about a very leisurely pace of normalization. The Fed believes that it will be “some time” before we reach “substantial further progress,” which will give Powell ample opportunity to alert financial markets well before a taper is announced. Then, several officials have indicated that the pace of tapering might be similar to the last cycle, when the first taper was announced in December 2013 and asset purchases did not end until October 2014. Subsequently, it was over a year later before the Fed lifted off, moving the fed funds rate target off of the zero bound. The FOMC still believes liftoff will not occur before 2024, as 11 out of 18 committee members kept their end-2023 dot at 0.125%.

Piecing these elements together, a timeframe for policy normalization might look like this:

  1. Talk about tapering: Late summer or fall 2021
  2. Initiate tapering: Early 2022
  3. End asset purchases: End 2022 to early 2023
  4. Liftoff: 2024.
  5. Allow balance sheet runoff: 2024 or later.

As Powell emphasized at his press conference, the Fed’s forecasts for 2023 and further are not of any particular value. If the economy surprises, the Fed’s policy projections will adjust. Having said that, the juxtaposition between the FOMC’s quite optimistic economic projections and its dot estimates are a striking declaration of dovishness. The FOMC is forecasting that at the end of 2023, the economy will have been operating beyond full employment for over a year, with inflation at or above its 2% target for three years—accepting that the FOMC is shooting for modestly above-target inflation for a time—and the Fed would still be maintaining the funds rate at the lower bound. That reflects a radically new monetary policy framework. By comparison, at liftoff in December 2015, the unemployment rate was above 5% and inflation was far below 2%, with the core PCE deflator running at 1.2% year-over-year and not accelerating.

Market pricing

Figuring out market pricing for rate hikes is a little tricky since they are likely so far out in the future. Fed funds futures do not trade much beyond 18 months. Eurodollar futures have been the traditional tool for determining market expectations for the Fed beyond a year or so, but with the LIBOR transition, it is not entirely clear if we should take the reds (the second year out) and greens (the third year out) literally. For what it is worth, the Eurodollar futures start to inch up noticeably in late 2022, pricing in part of one rate hike by the end of 2022 and then about 60 bp of rate increases in 2023, before addressing the nuances of term premia. SOFR futures are a relatively new and unproven metric with less trading volumes than Eurodollar futures at the moment, but they offer a third look into the future. SOFR 3-month futures currently have about 18 bp of increases in 2022 and another 55 bp in 2023, very consistent with Eurodollar futures.

Futures imply that market participants are somewhat less dovish than the FOMC, expecting the possibility of a move by the end of 2022 and perhaps a total of two to three quarter-point moves by the end of 2023.

Consensus of economists

Bloomberg conducted a survey of 41 economists shortly before this week’s FOMC meeting. The responses offer a clear picture of how economists expect the steps of normalization to play out. Most expected tapering to begin in either the last quarter of 2021 or the first quarter of 2022 and to last between seven months and 12 months. As for liftoff, the median estimate had the FOMC sticking to the lower bound through the end of 2022 but raising the funds rate by almost 50 bp in 2023. Economists are generally in sync with financial market participants on the timing of rate hikes and appear to be broadly following the FOMC’s guidance on the timing and pace of tapering.

My Projections

As has been the case since the early days of the pandemic, my economic forecasts are more optimistic than the FOMC’s. The latest SEP projections propelled the Fed to a more upbeat outlook than the private sector consensus, but my own projections are still more aggressive than the Fed’s. For example, I expect 8% real GDP growth this year (the Fed is at 6.5%), and I expect the unemployment rate to average about 4.25% in the fourth quarter of this year (the FOMC is at 4.5%). Perhaps most importantly, I look for inflation to accelerate further above 2% later this year than the FOMC does, and I expect inflation to remain noticeably above 2%, even after the temporary reopening burst in prices recedes.

With that as context, it should not be surprising that my timeframe for policy normalization is faster than the FOMC’s (or the private sector consensus). I believe that the recovery will be violent in the spring and summer of 2021, convincing the FOMC that “substantial further progress” has been achieved well before the end of the year. In fact, I look for an initial taper to be announced at the September FOMC meeting, to be implemented in October.

One of the most important distinctions that I would make between my forecasts and those of the FOMC is that I find the reliance on the last cycle as a template to be wholly inappropriate. Economic growth was sluggish and inflation was mostly below target during that period, allowing for a leisurely pace of normalization. In contrast, the economy, propelled by reopening from the pandemic restrictions and by unprecedented amounts of fiscal and monetary stimulus, is likely to rocket ahead in 2021 and 2022, which should require a quicker progression through the steps laid out above. I would expect the tapering process to be much shorter than in 2014, perhaps six months or less. Moreover, by the time the FOMC stops buying assets, in early 2022, the unemployment rate may already be in the 3%’s, signaling an economy operating beyond full employment (I also expect that labor force participation will have retraced the pandemic drop by then), and in stark contrast to the late 2010s, inflation as measured by the headline and core PCE deflators may be running well above 2%, perhaps in the 2½% neighborhood. Therefore, I look for the FOMC be forced to very quickly transition from tapering to rate hikes, perhaps lifting off as early as spring 2022.

Stephen Stanley
stephen.stanley@santander.us
1 (203) 428-2556

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This message, including any attachments or links contained herein, is subject to important disclaimers, conditions, and disclosures regarding Electronic Communications, which you can find at https://portfolio-strategy.apsec.com/sancap-disclaimers-and-disclosures.

Important Disclaimers

Copyright © 2024 Santander US Capital Markets LLC and its affiliates (“SCM”). All rights reserved. SCM is a member of FINRA and SIPC. This material is intended for limited distribution to institutions only and is not publicly available. Any unauthorized use or disclosure is prohibited.

In making this material available, SCM (i) is not providing any advice to the recipient, including, without limitation, any advice as to investment, legal, accounting, tax and financial matters, (ii) is not acting as an advisor or fiduciary in respect of the recipient, (iii) is not making any predictions or projections and (iv) intends that any recipient to which SCM has provided this material is an “institutional investor” (as defined under applicable law and regulation, including FINRA Rule 4512 and that this material will not be disseminated, in whole or part, to any third party by the recipient.

The author of this material is an economist, desk strategist or trader. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of SCM’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, SCM or any of its affiliates may act as a market maker or principal dealer and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

This material (i) has been prepared for information purposes only and does not constitute a solicitation or an offer to buy or sell any securities, related investments or other financial instruments, (ii) is neither research, a “research report” as commonly understood under the securities laws and regulations promulgated thereunder nor the product of a research department, (iii) or parts thereof may have been obtained from various sources, the reliability of which has not been verified and cannot be guaranteed by SCM, (iv) should not be reproduced or disclosed to any other person, without SCM’s prior consent and (v) is not intended for distribution in any jurisdiction in which its distribution would be prohibited.

In connection with this material, SCM (i) makes no representation or warranties as to the appropriateness or reliance for use in any transaction or as to the permissibility or legality of any financial instrument in any jurisdiction, (ii) believes the information in this material to be reliable, has not independently verified such information and makes no representation, express or implied, with regard to the accuracy or completeness of such information, (iii) accepts no responsibility or liability as to any reliance placed, or investment decision made, on the basis of such information by the recipient and (iv) does not undertake, and disclaims any duty to undertake, to update or to revise the information contained in this material.

Unless otherwise stated, the views, opinions, forecasts, valuations, or estimates contained in this material are those solely of the author, as of the date of publication of this material, and are subject to change without notice. The recipient of this material should make an independent evaluation of this information and make such other investigations as the recipient considers necessary (including obtaining independent financial advice), before transacting in any financial market or instrument discussed in or related to this material.

Important disclaimers for clients in the EU and UK

This publication has been prepared by Trading Desk Strategists within the Sales and Trading functions of Santander US Capital Markets LLC (“SanCap”), the US registered broker-dealer of Santander Corporate & Investment Banking. This communication is distributed in the EEA by Banco Santander S.A., a credit institution registered in Spain and authorised and regulated by the Bank of Spain and the CNMV. Any EEA recipient of this communication that would like to affect any transaction in any security or issuer discussed herein should do so with Banco Santander S.A. or any of its affiliates (together “Santander”). This communication has been distributed in the UK by Banco Santander, S.A.’s London branch, authorised by the Bank of Spain and subject to regulatory oversight on certain matters by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA).

The publication is intended for exclusive use for Professional Clients and Eligible Counterparties as defined by MiFID II and is not intended for use by retail customers or for any persons or entities in any jurisdictions or country where such distribution or use would be contrary to local law or regulation.

This material is not a product of Santander´s Research Team and does not constitute independent investment research. This is a marketing communication and may contain ¨investment recommendations¨ as defined by the Market Abuse Regulation 596/2014 ("MAR"). This publication has not been prepared in accordance with legal requirements designed to promote the independence of research and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The author, date and time of the production of this publication are as indicated herein.

This publication does not constitute investment advice and may not be relied upon to form an investment decision, nor should it be construed as any offer to sell or issue or invitation to purchase, acquire or subscribe for any instruments referred herein. The publication has been prepared in good faith and based on information Santander considers reliable as of the date of publication, but Santander does not guarantee or represent, express or implied, that such information is accurate or complete. All estimates, forecasts and opinions are current as at the date of this publication and are subject to change without notice. Unless otherwise indicated, Santander does not intend to update this publication. The views and commentary in this publication may not be objective or independent of the interests of the Trading and Sales functions of Santander, who may be active participants in the markets, investments or strategies referred to herein and/or may receive compensation from investment banking and non-investment banking services from entities mentioned herein. Santander may trade as principal, make a market or hold positions in instruments (or related derivatives) and/or hold financial interest in entities discussed herein. Santander may provide market commentary or trading strategies to other clients or engage in transactions which may differ from views expressed herein. Santander may have acted upon the contents of this publication prior to you having received it.

This publication is intended for the exclusive use of the recipient and must not be reproduced, redistributed or transmitted, in whole or in part, without Santander’s consent. The recipient agrees to keep confidential at all times information contained herein.

The Library

Search Articles