The U.S. Federal Reserve just completed its meetings on March 16 and 17, and issued an “optimistic” forecast of the U.S. economic outlook. It believed that in 2021, economic growth will reach 6.5%, inflation will be 2.2%, and unemployment will drop to 4.5%. This is a more optimistic outlook compared to before, therefore, although the Fed’s statement was confident, the market seemed to believe that the Fed may not be able to carry through with its words. The main reason is with the large-scale Covid vaccination, the stimulus relief program, and the expected economic recovery, people’s inflationary expectation naturally rises. At the time of writing, the U.S. 10-year bond yield sits above 1.6%, and even exceeded 1.7% previously. The market did not have a consensus on the Fed’s attitude, leading to fluctuations in the financial market. How should one understand the Fed’s future direction of monetary policy?

In the past, the market generally believed that whether the Fed’s interest rate hikes or not and the orientation of monetary policy were mainly decided based on the prospects of full employment and economic growth. However, in the last few years, the Fed’s attitude had in fact changed from forward-looking to observing actual economic growth, inflation, and job market dynamics before determining its policy direction. In other words, the Fed is no longer making forecasts, but has been relying on actual observation of economic data before making policy directions – especially regarding changes in employment in the market, the Fed’s policy-making direction has changed from a preventive one to a responsive one.

Only looking at the unemployment rate alone can be very misleading because the more long-term unemployed people give up looking for work and withdraw from the job market, there could be a false phenomenon that the unemployment rate has continued to drop. The employment participation rate (ratio of the employed population to the working-age population) can be more telling for the real job market situation. The latest employment participation rate in the U.S. is 61.4%, a drop from the previous average of 63% from 2013 to 2019. When the U.S. Federal Reserve Chairman Jerome Powell said several times that there is still a long way to go for a complete recovery in the U.S. economy, it was a conclusion based on this data. Therefore, the Fed will not raise interest rates until it sees an overall increase in the employment participation rate.

Other than the employment situation, the market is also worried that inflation will return quickly and rapidly after the large-scale vaccination, then the Fed will inevitably raise interest rates at that time. However, it seems like there is still control over this area, mainly because as the U.S. remains under the impact of the virus, the savings rate in the U.S. has been relatively high. The current ratio of savings to disposable income is 21%, compared to the average ratio of 6% over the past 10 years. With the high savings rate, inflation should remain under control. However, of course, when the job market continues to recover, and once people calm down, the savings rate will fall, and inflation will follow by rising. Therefore we must always pay attention to the interaction between “real wages” and “productivity”. Simply put, if the rate of real wages increases greatly exceeds the increase in productivity, then inflation will also come very quickly, however, we’re not there yet.

(Wilson Tang, Executive Director, Treasures Private Client, DBS Bank (Hong Kong) Limited)

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