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Fed Threads the Needle with Short-Term Hawkish, Long-Term Dovish Message

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Fed Threads the Needle with Short-Term Hawkish, Long-Term Dovish Message

Boston - At the December 14-15 meeting of the Federal Open Market Committee (FOMC), policymakers appeared to thread the needle perfectly, with a message of accelerated tapering and rate increases.

"While headlines have stressed the Fed's intention to start hiking rates earlier than anticipated, the central bank also plans to end the rate hikes sooner: The dot plot now shows three hikes in 2023 and just two in 2024."
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By Eric Stein, CFAChief Investment Officer, Fixed Income, Eaton Vance Management

Boston - At the December 14-15 meeting of the Federal Open Market Committee (FOMC), policymakers appeared to thread the needle perfectly, with a message of accelerated tapering and rate increases.

The Fed announced it would double to $30 billion the tapering of its purchases of U.S. Treasury issues and mortgage securities, putting it on a pace to finish tapering by March instead of June. Additionally, the median "dot plot" projection for rate hikes was bumped up from two to three in 2022.

Fed monetary policy updates

While headlines have stressed the Fed's intention to start hiking rates earlier than anticipated, the central bank also plans to end the rate hikes sooner: The dot plot now shows three hikes in 2023 and just two in 2024 — originally scheduled for three. The federal funds rate is seen as moving from 0.1% in 2021 to 0.9% in 2022, 1.6% in 2023 and 2.1% in 2024. Versus the September dot plot, the projections are 60 basis points (bps) higher in 2022 and 2023, and 30 bps higher in 2024. The Fed's "long-run" projection of 2.5% remains unchanged.

Consistent with Fed Chair Jerome Powell's Congressional testimony earlier in December, "transitory" has been omitted from the FOMC's statement regarding inflation. Instead, the statement simply observes that "supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation," noting "substantial" declines in unemployment and "solid" job gains.

Our take on the Fed's actions and the market reaction

We view this as a really moderate message — short-term hawkish but long-term dovish. The financial markets' first reaction appeared to agree with that: The initial yield curve flattening wound up as a slight steepening, with short-term rates staying put and the long end increasing by four bps.

We have seen a lot of yield curve flattening recently, so we view the steepening as a good thing. The U.S. dollar was broadly weaker in a risk-on session, stocks advanced and closed at the high for the day. It would be a mistake to read too much into the initial market reaction, nevertheless we suspect the Fed would view that reaction as positive. After all, the idea is to have the market price in more hikes without shocking the system, tightening too much and inverting the yield curve.

Bottom line: The Fed has acknowledged the reality of higher inflation and accelerated the timetable for dealing with it. The market clearly took comfort from the "short-term hawkish, long-term dovish" approach to threading the needle. We expect it won't be the last time the Fed will have to do this.