What to Expect for Interest Rates in 2021?

A series of electronic charts and graphs meant to represent an analysis of interest rates.

In the midst the recent Presidential election, the FOMC (Federal Open Market Committee) elected to keep interest rates near zero, as expected. The ongoing COVID-19 pandemic and the related uncertainty is expected to anchor interest rates at their current levels for quite some time, despite solid labor market gains and upticks in inflation that have been seen during the past few months. So, when do investors expect interest rate hikes, and what indicators should be watched in 2021?

Jerome Powell Confident in Monetary Policy Firepower

While GDP growth in the U.S. has recovered significantly following the abrupt shutdowns in March, that growth has been moderating and remains below pre-pandemic levels. The course for monetary policy depends heavily on how the COVID-19 pandemic progresses, and unfortunately, many countries are seeing a spike in cases as we head into the winter. Downside risks from the ongoing pandemic could continue to be prevalent and suppress growth, inflation and interest rates.

Along with the expectation of keeping interest rates near zero for years, Fed Chairman Jerome Powell and company are investigating extensions to lending programs implemented in the wake of the pandemic induced lockdowns. The Main Street Lending Program [MSLP] recently saw the minimum loan threshold lowered to $100,000, which should provide more accessibility to smaller businesses. Asset purchases by The Fed are also expected to continue at the current rate as they help promote smooth financial market functionality. Should the need arise, Powell is confident that the Fed still has powerful tools at its disposal.

Current Interest Rate Risks

The Fed expects to keep interest rates near zero until labor market conditions improve and inflation has rebounded to the new two percent average target. This new target seeks to maintain an average rate of inflation of two percent over time. This will allow the rate to rise above and dip below the target rate, following extended periods of high or low inflation.

The Fed is unlikely to tighten monetary policy until inflation is on track to moderately exceed the two percent target. Because the language was designed to be flexible, it is hard to know the ceiling on short-term inflation. Most Federal Reserve Bank Presidents that have weighed in see that level being around 2.3%-2.5%.

Many recent labor market measures have continued to beat expectations. October continued that trend with the addition of 638,000 new jobs and the unemployment rate dropping to 6.9%. The current streak of job creation, along with a 0.3 percentage point increase in the labor force participation rate, is overshadowed by consistently elevated layoffs. New unemployment insurance claims remain around the 750,000 mark, which is well above the pre-pandemic record of 695,000. In addition, the new wave of COVID-19 cases emerging around the globe could jeopardize this stronger-than-expected job market recovery.

Current measures of inflation have been accelerating, since bottoming out in the Spring. Low oil prices are dragging down the overall measure of consumer prices, but “core” measures, those excluding food and energy, are nearing pre-pandemic levels. Core PCE for September was 1.5%, and core CPI was up 1.7% year-over-year.

For comparison, average core PCE inflation for the fourth quarter of 2019 was 1.57%, following the summer rate cuts. However, even with some of the lowest unemployment figures in recent history, and interest rates around 1.5%, the economy was not seeing significant price growth prior to the pandemic.

What to expect from the Fed in the 2021 and beyond?

The Fed is going to be watching the course of the pandemic closely as it makes monetary policy decisions. If a large spike in cases results in the reinstitution of lockdown measures, dovish policy and more lending facilities are likely. Also, the Fed has been calling for further fiscal stimulus from Congress, acknowledging that there are limitations to the reach of monetary policy. If the Senate remains in GOP control, the size of any stimulus could be smaller than Democrats would prefer.

Labor market gains and inflation are two indicators to watch closely as we move forward. While inflation is still low, it has picked up significantly for certain goods and services affected by the loosening of restrictions and low interest rates, like automobiles. The labor market is still around 10 million jobs short of pre-pandemic levels, so there is a long way to go before the criterion for full employment are reached and the Fed is comfortable raising interest rates.

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