Central bank warms to scaling back pandemic-driven supportive measures

For months, U.S. Federal Reserve Chair Jerome Powell and other central bank officials cast a sense of measured calm about surging inflationary pressures, explaining that rising prices were a temporary part of the U.S. economy's recovery from its dramatic drop at the onset of the pandemic.

On June 16, Fed policymakers acknowledged that their patience has its limits.

During a regularly scheduled meeting, 11 of 18 officials projected two rate hikes during 2023, a year previously deemed off-limits as the U.S. economy continued to heal from the 2020 recession. The Fed also substantially boosted its full-year inflation and economic growth projections.

"It's definitely a shift in thinking, and we can't be certain about what specifically drove it," said Brian Henderson, chief investment officer at BOK Financial^®. "Maybe it was the higher inflation data we've been seeing or a concern that bubbles are building in certain pockets of the economy—specifically, the financial markets and housing market.

"But with this move, I think the risk of inflation and inflation expectations getting unhinged and rising much higher has been cut off. The Fed is saying ‘we're not asleep at the wheel, and we'll hike rates if we see inflation get carried away.'"

The Fed strives to keep the economy's growth rate in a healthy range by keeping both inflation and the nation's unemployment rate low. If the economy grows too quickly, prices tend to increase more dramatically in response to rising consumption levels.

In May, consumer prices rose 0.6%, which followed a 0.8% increase in April and contributed to the Fed's revised full-year inflation forecast of 3.4%, a full percentage point higher than its March projection.

As for the unemployment rate, which sat at 5.8% in May, the Fed officials projected a decline to 4.5% in the fourth quarter of this year.

"The economy is a lot better than where it was last year, but 5.8% unemployment is high and there are still millions collecting unemployment," Henderson said. "So the news regarding potential rate hikes as soon as 2023 is definitely a surprise because Fed officials have been downplaying inflation—saying it's transitory—and explaining that there's still a lot of capacity in the labor market."

In addition, the Fed upped its gross domestic product growth rate projection to 7.0%, up from 6.5% in March.

"Considering we're halfway through the year, that's a very high expectation for growth, and it raises concerns about what could cause that growth rate to miss projections," Henderson said. "While I'm not as concerned about risks around a COVID variant as I was at the beginning of the year, I am worried that consumers may start to say prices are too high, which could lead to a pullback in spending habits that disappoints the market."

From an investment perspective, Henderson believes the divergence between large capitalization value stocks and growth-oriented stocks could narrow in the wake of the recent Fed news. Value names viewed as benefiting from the reopening push have largely led the market while generally outperforming traditional growth stocks since late 2020.

As for bonds, Henderson sees future increases in long-term rates, which move in the opposite direction of prices, limited by the central bank's moderated inflation expectations.

One wild card remains: the Fed's decision on winding down its current quantitative easing campaign, in which the central bank purchases $120 billion worth of government bonds on a monthly basis. That program must be completely ended before the Fed starts raising rates, although Powell said the timing has yet to be determined.

"They've got to start setting the market up for the tapering of quantitative easing, and I would guess we'll hear more about that later this summer," Henderson said.