Slower reversal of inflation spike prompts changes to Fed call
Prompted by recent developments, of which the most important was a revised outlook for inflation that includes a more gradual reversal of the current spike of inflation and correspondingly increased risk that long-run inflation expectations might rise above the Fed's longer-run 2% target, IHS Markit has updated our monetary policy outlook. We now expect the Fed to begin increasing interest rates and end bond purchases earlier. Additionally, we expect the Fed will return to an approximately neutral stance of interest-rate policy faster, albeit still gradually.
Taper of asset purchases
We anticipate the Fed will begin to reduce the pace of asset purchases next month, lowering them gradually to zero by next June. (This could be accomplished with regular planned declines in the pace of purchases of $15 billion per month.) The start of the taper is unchanged from prior forecasts, but we now assume an earlier end to such purchases (June 2022 instead of October 2022). The Fed's securities portfolio is projected to rise to $8.5 trillion, approximately $200 billion less than previously assumed.
We anticipate the Fed will implement the first increase in the target for the federal funds rate from its current range of 0% to 0.25% in March 2023, six months earlier than our prior forecast. Furthermore, we accelerated the pace of rate hikes after the initial lift-off. The nominal federal funds rate target is assumed to rise to an approximately neutral setting (a range of 2.5% to 2.75%) in 2027, one year earlier than previously anticipated.
We continue to anticipate that the current spike of inflation will prove to be mostly transitory. However, more persistent supply-chain bottlenecks suggest that some pandemic-related price increases could prove to be more persistent than previously anticipated. In addition, the substantial surge in house prices has resulted in a large increase in the ratio of house prices to rents. We assume some easing in house price inflation, to be sure, but a narrowing of the gap between rents and house prices is expected due to a firming of rent inflation.
Our assumptions still reflect a cautious and gradual shrinkage of the extraordinary monetary policy accommodation that was engineered last year by the Federal Reserve. Seven years will have elapsed from the time of the pandemic-related policy interventions in March 2020 and a return to an approximately neutral stance for interest-rate policy. The Fed's securities portfolio will stop expanding in mid-2022, only a little more than two years after the pandemic-related interventions, but the possibility of any reduction in the nominal size of that portfolio is still some years in the future.
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