Federal Reserve Review - Inflation Concern Leads to Hawkish Turn

The Fed raised its core PCE forecast for 2021 to 3%, but still views the high inflation as transitory. However, the majority of FOMC participants see upside risks to it. As a result, two rate hikes were penciled in to the dot plot for 2023. This was perceived by market participants as a hawkish turn - a signal that the Fed sees the inflation overshoot this year as sufficient under its average inflation targeting framework. Meanwhile, the Fed still sees a strong labor market recovery this year. Hence, if this recovery is confirmed in the coming months and if inflation remains high, the Fed will turn more hawkish, which will underpin strength in the dollar.Yesterday, the Fed left rates unchanged and updated its economic forecasts. Thanks to progress in vaccination, it lifted this year's GDP growth forecast to 7.0%, from the 6.5% it had expected back in March. Moreover, it expressed confidence in the labor market recovery this year, maintaining its 4.5% unemployment forecast for the year, despite the disappointing NFP numbers in April-May. The Fed expects this to happen on the back of reduced fears about the coronavirus, less need for childcare when the school year begins in autumn and the cancellation of additional unemployment benefits, which has already started in some states (Republican-ruled ones). Still, the Fed admitted that risks to the economic outlook remained and that there hadn't been enough progress in the labor market recovery, so QE volumes were left unchanged. Powell did note that the Fed has started "talking about talking about tapering."As expected, inflation and the dot plot were in the spotlight. The Fed still sees the elevated inflation as transitory and expects its pace to moderate from 3.8% y-o-y in May (core CPI) to 3.0% and 2.1% in 2021 and 2022, respectively (core PCE). However, 13 of the 18 FOMC members expressed concern about upside risks to inflation.Meanwhile, a majority of FOMC members are now expecting at least two 25 bp hikes by end-2023. Though this had been more or less priced in by dollar rates markets, it still came as a hawkish surprise. Combined with inflation concerns, it seems to have been taken by the market as a signal that the Fed - within the framework of its broad inflation targeting - views the pickup in inflation this year as sufficient to justify tightening policy moving forward. Recall that the Fed believes that inflation should run above 2% for a certain amount of time to make up for the previous years when it was below the 2% target (for example, since 2011 inflation has undershot the 2% target by about 2.6%, while in March before of the April-May spike it had undershot by around 4%). But just how long inflation should run hot is for the Fed to decide, and currently it seems that the Fed sees it as shorter rather than longer.Against this backdrop, UST nominal and real yields surged yesterday. In particular, the 2y yield rose 4 bps to above 0.20% (its highest level in a year). One 25 bp rate hike is now priced in by end-2022 and almost two are priced in for 2023. Given that moves in shorter-dated rates and yields are especially important for exchange rates, the dollar, as could have been expected, gained around 1% yesterday on DM peers and has extended its gains today, while the euro has weakened below the important 1.20 level.If the strong recovery in the US labor market is confirmed in coming months and inflation remains high without decelerating significantly, we think the Fed will turn more hawkish, which will boost the dollar. Thus, we expect tailwinds to continue for the greenback, which could appreciate against the euro to 1.19 in June and to 1.15 by year-end.