Federal Reserve maintains interest rate despite near-term inflation

Key takeaways

• The U.S. Federal Reserve (Fed) reaffirmed its supportive monetary policy, maintaining low interest rates and continuing asset purchases despite recent inflationary pressure.
• More than half of Fed committee members expect interest rate increases in 2023 and initiated discussions on when to reduce asset purchases, highlighting the committee’s optimistic economic outlook.
• Today’s announcement is consistent with our constructive outlook on the economy, and we highlight potential inflation hedges in the event rising prices persist.

As expected, the Fed held its target interest rates unchanged and near zero today following its regularly scheduled two-day meeting. The Fed noted the improving economic outlook and maintained its current pro-growth policies, citing the need for further economic progress before reducing asset purchases and eventually lifting interest rates. Our positive outlook for diversified portfolios remains intact based on ongoing fiscal and monetary policy stimulus, the economic reopening progress and supportive corporate fundamentals, though elevated asset valuations and the rising risk of more persistent inflation remain risks to our view.

Stock prices as measured by the S&P 500 Index fell today while Treasury yields jumped based on earlier rate hike expectations embedded in the Fed’s announcement. The 10-year Treasury bond currently yields 1.56 percent, up from 0.92 percent at the beginning of the year but down from the 2021 high near 1.76 percent in March.

During the ensuing press conference, Fed Chairman Jerome Powell highlighted strong economic progress while noting the uncertain nature of forward projections. Importantly, Chairman Powell reiterated near-term price inflation is likely to be transitory (short-lived) and highlighted the ongoing need to support the labor market’s recovery. Payrolls remain lower by 7.6 million jobs versus pre-pandemic levels, which remains the primary focus of supportive monetary policy at this juncture. Market-based inflation measures align with the Fed’s transitory view on inflation, although surveys on forward-looking inflation continue rising. It remains unclear if accelerating broad inflation measures such as the Consumer Price Index (CPI) indicate transitory factors or structural price pressures.

The Fed supported its transitory inflation view and constructive outlook through an updated Summary of Economic Projections (SEP), which acknowledges higher inflation through 2021 but near-target inflation in 2022 and beyond. The SEP also shows seven of 18 members expect the initial interest rate hike in 2022 (up from four in March) and 13 expecting at least one hike by the end of 2023 (up from seven in March), with 11 members expecting two hikes by the end of 2023. We anticipate ample foreshadowing prior to beginning asset purchase reductions in early 2022, with the first hike likely in late 2022 or 2023.

We retain our glass half-full perspective on the capital market opportunity set ahead. The Fed’s ongoing policy support, fiscal stimulus, along with COVID vaccination progress and strong company fundamentals, outweigh uncertainties for now. However, we also remain vigilant to risks to our outlook and we will communicate any changes to our perspectives.

An important emerging consideration is rising inflation, including the debate around whether price increases will prove temporary or remain persistent and the potential impact on diversified portfolios. In July 2020, we distributed a paper titled, “Investing when inflation is on the rise,” in which we highlighted investments that tend to perform well in environments of rising inflation. Our view remains that rising prices are unlikely to cause a material economic disruption or trigger a significant drop in diversified portfolio values in the next two to three years, but we acknowledge it remains a risk. Diversified portfolios are critical in hedging against a variety of risks, including inflation. Our findings indicate stocks, for example, have some degree of natural inflation protection, particularly larger companies. Commodities, real estate, Treasury Inflation Protected Securities (TIPS) and certain customized strategies can also play a role generating stronger portfolio performance in the event inflation rises beyond current expectations. We encourage reaching out to your financial professional to discuss the relationship between potential market risks, including inflation, with respect to your unique circumstance.

As always, we value your trust and are here to help in any way we can. Please do not hesitate to let us know if we can help address your unique financial situation or be of assistance.

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