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Fed delivers "hawkish surprise" as economy — and inflation risk — grow

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By Eric Stein, CFAChief Investment Officer, Fixed Income, Eaton Vance Management

Boston - The June 16 meeting of the Federal Open Market Committee delivered a bit of a hawkish surprise, as the consensus projection for new rate hikes moved up to 2023, compared with March when no FOMC members predicted hikes that early.

The Fed's traditional "dot plot" for 2022 also showed a hawkish shift, with seven members predicting a hike by then, compared with four in March (though these are not median projections).

There was generally more optimism about the economy, with things getting back on track, and even some acknowledgment from Fed Chair Jerome Powell that inflation might be too high. Not a lot of acknowledgment, but the little that was forthcoming was significant.

These sentiments were mirrored in upward revisions from the Fed's March economic forecasts, in which inflation — as measured by personal consumption expenditures, or PCE — was predicted to grow by 3.4% in 2021 (up from 2.4% in March), and real GDP growth for 2021 was bumped up to 7.0% (from 6.5% in March).

A similar change in tone was reflected in the Fed's statement, which asserted that "progress on vaccinations will likely continue to reduce the effects of the public health crisis on the economy," versus prior language that "the ongoing public health crisis continues to weigh on the economy."

The Fed also noted upward technical adjustments to its interest rate on excess reserves (IOER) and overnight reverse repurchase agreements (ONRRP). These were designed to raise the floor rate for money market funds, and to prevent them from going negative, given the flood of liquidity in the system and pressure at the front end of the yield curve. While separate from its monetary policy actions, directionally the move up in rates was similar.

The market reacted as one might expect from hawkish Fed signals. We saw something of a bear flattening of the yield curve, with the front end rising more than the back end, while the breakeven rate, which measures inflation expectations, lost some ground. The U.S. dollar was significantly stronger after the meeting, and the strength continued through the June 17 "morning after."

I believe that is what the Fed intended. However, I don't think policymakers want real rates to rise or the dollar to strengthen that much. It is part of the ebb and flow that the central bank is trying to manage in its efforts to tighten financial conditions without choking off the recovery.

It will be interesting to see whether there will be much carry through in today's market reaction. Sometimes we observe a temporary knee-jerk reaction to hawkish Fed statements, and other times the impact is more long-lasting.

Bottom line: All in all, the Fed took an unexpectedly hawkish turn, and the market certainly took it that way. Stay tuned.