MNI EXCLUSIVE: Next Fed SEP Set to Show Growing Optimism

The Federal Reserve could become more bullish about the economy's prospects by the time it issues the next round of forecasts in June, complicating the central bank's message that it is in no hurry to tighten monetary policy, current and former Fed officials told MNI.

"Fast forward to June, if all goes well, they're going to have to mark up their forecast," said Joseph Gagnon, a former Fed board economist, in an interview. He noted first quarter data were already coming in stronger-than-expected despite a Covid surge.

At the same time, however, "they may not be ready yet to talk about tapering or raising rates. It's going to be a tougher conversation in June than it was in March."

Gagnon said he sees further room for upward revisions to the Fed's growth outlook, which now foresees a 6.5% expansion this year.

There's even a chance the Fed's dots might begin to show a median forecast for a rate hike in 2023. That would nudge it toward -- but still a ways from -- Wall Street's more aggressive estimate for rate increases as early as 2022.

"We could get a virtuous cycle where we really take off on a real growth spurt for more than just the balance of this year -- I hope for it," said Jeff Fuhrer, former senior economist and policy advisor at the Boston Fed.

"It's a forecast and things can change. The Fed will, if it sees good reason, revise its forecast," Fuhrer said. "Treasury and the TIPS and implied breakevens are showing some concern that growth will be stronger and some concern that the Fed will be slow to react."

FISCAL CURVE BALL

The Fed's increasing willingness to acknowledge progress on the Covid front in coming months, as well as the data boost from the Biden administration's historic USD1.9 trillion stimulus package, may bring it more in line with increasingly bullish Wall Street estimates.

"I actually think there is an upside risk we could end up with even stronger growth," than the 6.5% he is currently forecasting for 2021, St. Louis Fed President James Bullard told reporters Tuesday in response to a question from MNI.

That sense of deep uncertainty about just how strong the emergence from this recovery might be now that the fiscal wild card has been introduced is shared fairly broadly within the Fed system, current and former officials say.

"Medium-term inflation outcomes have become substantially more uncertain --even though many measures of expected inflation have remained relatively stable," said Christian Matthes, senior economist at the Richmond Fed until 2020.

"Many economic theories would predict more inflationary pressure coming from recent changes to fiscal policy. I do not think those predictions are unreasonable."

Another thing that might be holding Fed forecasters back is lingering caution about predicting an end to the pandemic despite the faster-than-expected vaccination schedule.

"My feeling is that the Fed and other forecasters are still factoring in some probability that the pandemic recovery will not be as successful as we hope," Gagnon said.

"If that risk fell away and we know that by the end of summer everything will be wide open -- I think you'd have to raise the forecast, just because of the size of the fiscal spending."

DRAMATIC EXPERIMENT

Gagnon noted the U.S. has never approved a relief package of that magnitude outside of wartime.

"This stimulus is just so big that you have to assume very unusually high savings rates to keep it from stimulating the economy," he said. "I get that there's a lot of uncertainty about how much excess capacity there is in the economy -- but there's not that much uncertainty."

Ex-Fed Governor Jeremy Stein agrees. "We don't have a great understanding of inflation dynamics and now we're conducting a pretty dramatic experiment."

If bond markets become fixated on inflation risks -- there are already signs of this -- then they could start to move in tandem rather than inversely to stock prices, Stein said. That would trap the Fed because responding to inflation fears with even more easing or reassurances about easy policy might be self-defeating under such a scenario.

"I wouldn't necessarily worry that we are going to see a sustained increase in inflation—it's the interaction of a potential temporary spike with financial markets that are priced aggressively that strikes me as the more relevant concern."

MNI exclusively reported the Fed's "dot plot" of rate forecasts would shift in a more hawkish direction ahead of the March meeting. The new SEP showed four officials predicting a rate hike in 2022, up from one in December, and seven seeing one in 2023, versus just five in December.