On U.S. Fixed Income
The Fed Surreptitiously Turns Dovish
SEP reveals a renewed commitment to average inflation targeting.
Stephen Bartolini, CFA Co-head of global interest rate strategy and Portfolio Manager, New Income Fund
Steven Boothe, CFA Head of investment-grade and Co-portfolio Manager, Corporate Income Fund
Key Insights
  • An examination of the September FOMC meeting’s summary of economic projections reveals that the Fed has surreptitiously made a dovish turn in monetary policy.
  • The FOMC is showing renewed commitment to the average inflation targeting framework, which can result in higher yields and a steeper yield curve.
  • Stubbornly high inflation must recede to allow this new framework to proceed, which will be the focus of markets over the coming months.

The September Federal Open Market Committee (FOMC) meeting left the lasting impression on most that the conditions for tapering quantitative easing (QE) have been “all but met”1 and a reduction in purchases “may soon be warranted.”2 One could assume that, by themselves, these phrases represent a further hawkish3 shift by the FOMC. Moving past the taper discussion, however, closes a hawkish chapter for the Federal Reserve (Fed). The next chapter was revealed in the summary of economic projections (SEP),4 and it is overwhelmingly dovish.5

SEP Indicates Dovish Policy Stance for Years

The SEP is much maligned, but it is a highly informative and valuable indicator of the FOMC reaction function. The September SEP indicated an extremely dovish reaction function. The median projections (see charts below) indicate four years of inflation running above target and three years of below 4% unemployment, but the 2024 federal funds rate median (the 2024 “dot”) is only at 1.75%, 0.75% below the long-run, or neutral, rate. That is incredibly dovish!

The medians or “dots” for 2023 and 2024 did move slightly higher, but in revealing the 2024 dot, the FOMC indicated it would be in a highly accommodative stance years after having achieved its objectives. Within any historical context, these projections make no sense—but perhaps this is the new, average inflation targeting framework6 in action. The SEP suggests the post-taper period will likely be punctuated by a comeback of average inflation targeting and a re-affirmation of the new framework. The FOMC has taken a first successful step in separating the tapering decision from the tightening decision.

SEP Reveals Dovish Long-Run Stance
SEP Reveals Dovish Long-Run Stance

As of September 22, 2021.
Data provided is for illustrative and informational purposes only. There can be no assurance that the estimates will be achieved or sustained.
Actual results may vary.

Source: Summary of Economic Projections.
*Personal consumption expenditure.

Probabilities of Higher Yields, Steeper Curve Have Increased

What does this mean for U.S. Treasury yields? The taper negotiation, which began in May, was a major component of the summer decline in yields. The market had difficulty processing a net hawkish shift from the FOMC at a time when supply constraints were pushing inflation higher and growth lower. Getting on with the taper resolves the negotiation and has allowed yields to release higher from their summer range. Post-taper, an FOMC showing renewed commitment to the average inflation targeting framework can result in a continuation of the current trend of higher yields and a steeper curve. Somewhat controversially, though, it will not likely be higher inflation but an easing of inflation that leads to higher yields.

Paradox of Lower Inflation Potentially Leading to Higher Yields

At this point in this particular cycle, lower inflation means higher yields, which is the opposite of the typical dynamic. This paradox is present purely because the source of inflation now is shortage-induced, cost-push price pressure. Stubbornly high inflation has taxed growth and led the FOMC into a protracted taper discussion, which raised questions about whether we were in a stagflationary7 environment.  

There are many reasons to believe that inflation will remain above 2%, but for this potentially stagflationary environment to recede and allow the FOMC to pursue average inflation targeting, supply side inflation pressure must dissipate. From an expectations standpoint, this is already happening. Expectations for inflation were laughably low earlier this year and have now adjusted much higher. Inflation is not sneaking up on anyone anymore; it has space to ease lower.  

The Next Phase of Monetary Policy

The September FOMC meeting presented a surreptitiously dovish outcome, indicating that the next phase of monetary policy is a renewed commitment to the still relatively new average inflation targeting framework. This framework supports strong future economic outcomes, which can lead a renewed push higher in yields. Stubbornly high inflation must recede to allow this new framework to breathe; while early indications suggest this process has begun, that will be the focus of markets over the coming months.

What We’re Watching Next
We monitor surprises in economic statistics, measured in terms of how much an actual data point exceeds or falls short of consensus expectations. Economic data surprises were consistently negative over the summer, which helped limit any increases in Treasury yields. Positive data surprises could help clear the way for another leg higher in yields.

1 Federal Reserve Chair Jerome Powell’s post-meeting press conference, September 22, 2021.

2 FOMC statement, September 22, 2021.

3 A hawkish stance leans toward tighter monetary policy.

4 The SEP includes forecasts of inflation, interest rates, and other economic variables from FOMC meeting participants.

5 A dovish stance leans toward looser monetary policy.

6 The framework involves letting inflation run above the 2% target, without preemptively raising rates, until the economy reaches full employment.

7 Stagflation is an environment of low growth and high inflation.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of October 2021 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates. Debt securities could suffer an adverse change in financial condition due to a ratings downgrade or default, which may affect the value of an investment. Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rate rise, bond prices generally fall.

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Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy. Actual future outcomes may differ materially from estimates and forward-looking statements made.

Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.

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