Inflation Surges – Will Interest Rates Follow?

Several financial charts overlayed upon each other. This is meant to represent an analysis of interest rates and inflation.

The June meeting of the FOMC concluded with an announcement that interest rates are expected to remain near zero throughout 2021 and 2022. However, the next hike is now projected to come sooner than originally anticipated.

Recent inflation data has shown drastic increases in both consumer and producer prices. This data led the FOMC to raise their inflation predictions for 2021, which jumped 1% in their most recent announcement. The Fed maintains that the drastic increase in inflation data is temporary and expected to calm after pandemic-related shortages and supply chain problems ease.

Interest rates remain near zero, but the timeline for rate hikes is moved forward.

On June 16, the Fed released their latest projections showing that the Fed Funds rate is expected to stay near zero through 2021 and 2022. As of the June meeting, the next rate hike is expected to arrive as early as 2023, and there may be two in that year.

At their last meeting, the FOMC predicted that rate increases would be delayed until 2024, but with recent rises in inflation data, they have slightly accelerated this timeline. In addition to keeping the Fed Funds rate near zero for the next year and a half, the Fed maintains they will continue buying $120 billion of treasury and agency mortgage-backed securities per month to maintain a low cost of borrowing.

In another policy update on June 2nd, the Fed announced they will begin selling the corporate debt they acquired during the pandemic. The announcement included language indicating that the selloff would proceed in a gradual and orderly fashion. As of April 30, 2021, their corporate debt holdings were valued at approximately $13.7 billion. These holdings are comprised of corporate bonds and corporate bond ETFs. Selling these securities is unlikely to have a major impact on the debt markets, but it does show that the Fed is beginning to think about tightening policy.

Inflation Numbers on the Rise, Outlook Remains Positive

The June update also included a significant increase to the Fed’s inflation projections. At their meeting in March, their inflation estimate was 2.4% for 2021, and this number has now risen to 3.4%. The update also included small changes to inflation projections for future years, with 2022 adjusting slightly upward by 0.1%. These projections support the Fed’s expectations that inflation will temper once supply chain issues have subsided.

May also recorded a 0.6% increase in the Consumer Price Index [CPI] from the prior month and a 5% increase year-over-year. The Energy sector remained steady from April to May, but it has seen the largest increase year-over-year of 28%. In addition, transportation costs continue to be a large contributor to overall inflation. Core CPI, which excludes food and energy, increased by 3.8% year-over-year, and that figure represents the largest 12-month increase since June 1992.

Some industries are showing evidence that supports the Fed’s claim of transitory inflation, and that is good news for the economy. For example, lumber prices are down 40% from their high in May 2021 but are still much higher than pre-pandemic levels. Additionally, rising mortgage rates could begin to put some downward pressure on a red-hot housing market.

Overall, the Fed’s outlook remains positive for the long-term, and they expect a return to more normal inflation and unemployment numbers as soon as 2022. Then if all goes as planned, expect to see interest rates on the rise in 2023.

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