Uncertainty over Fed’s reaction function

We are confident in our new forecasts that GDP growth will be a disappointing 2.7% in 2022 and 2.0% in 2023, while core inflation remains elevated at close to 3%, but we are less confident in our predictions of how the Fed will react to that particular set of circumstances. We have assumed that, given achieving the full employment goal is now supposed to be the Fed’s primary concern, it will put more weight on the relative undershoot in real GDP growth compared with its current projections. To our minds, that will persuade the Fed to delay the first interest rate hike until early 2023, even though underlying inflation is likely to be persistently above target. But markets are rapidly coming round to the idea that the Fed could hike rate sooner and more aggressively, and we freely acknowledge that there is a risk officials panic when the realise that core inflation isn’t going to drop back close to the 2% target next year. The bottom line is that the next couple of years will bring the first real test of the Fed’s new monetary framework and it remains to be seen exactly how that will shake out.