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FOMC preview: How optimistic is too optimistic for the US economy?

·7 min read
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The Federal Reserve is running into a unique challenge as it kicks off its second policy-setting meeting of the year: maintaining easy monetary policy through what could be the fastest economic recovery in history.

“There’s a lot left to do,” said Fed Chairman Jerome Powell at a Wall Street Journal event on March 4. “We have a lot of ground left to cover and good reason for optimism.”

The Federal Open Market Committee (FOMC) is expected to release its quarterly economic forecasts on where employment and prices are headed over the next three years. Since its last print in December, Congress has passed almost $3 trillion in fiscal stimulus.

As a result, Fed officials are likely to pencil in expectations for greater economic growth, lower unemployment, and a nudge up in inflation compared to previous forecasts.

Dot plots

But the bigger challenge: the Fed’s forecasts on where interest rates are headed. For a central bank that has emphasized it is not “thinking about” raising rates, markets could run away with projections that, for example, signal the possibility of a rate hike in 2022 or 2023.

“If I were [Fed Chairman] Jay Powell, that’s kind of the communications issue I’d be worried about,” said former FOMC staffer Bill English, now a professor in practice at the Yale School of Management.

Markets have already been pricing in the expectation of an earlier Fed hike. The yield on the 10-year U.S. Treasury, a proxy for longer-term interest rates, has surged over 60 basis points since the last FOMC meeting.

As of Monday afternoon, the 10-year yield sat at 1.61%. That pricing implies bond market bets that the Fed will raise rates by the end of 2022.

In its economic projections, the Fed could validate those market bets by pulling forward the timing for an expected rate hike. But the Fed could also hold the line on its December forecast of no rate hike through the end of 2023.

A "dot plot" chart from the December 16, 2020 FOMC meeting. Released as part of the Fed's Summary of Economic Projections, the dot plot maps out each FOMC member's expectations for where interest rates will go in the near-term. Source: Federal Reserve

Deutsche Bank Research expects something in the middle: for the median FOMC member to plot a 25 basis point rate hike by the end of 2023.

“The Fed would still signal that, in their assessment, the market is wrong about the timing of liftoff,” DB Research’s team wrote on March 11.

Inflation expectations

Rising bond yields have nonetheless caught the attention of Fed policymakers, who have largely attributed the market action to rising optimism over the post-pandemic economy.

The question is: Where is the tipping point on inflation?

With the Fed now willing to let inflation rise above its 2% target, the central bank is telegraphing to markets that tighter monetary policy will not be the immediate consequence of signs of price increases.

“I don’t judge [bond yields] going up as a negative sign,” San Francisco President Mary Daly told reporters on March 2. “I judge it as the incorporation of the environment that they’re observing, but also the understanding that the Fed’s not going to stop inflation before it hits 2%.”

But at some point, inflation reaches a level where the Fed does begin pulling back on its asset purchases and its near-zero interest rates. Those medium-to-long term inflation expectations are the concern of 10-year bond yields.

“This sort of issue was going to come up at some point,” Bill English told Yahoo Finance. “As the recovery goes along, at some point you get closer to when purchases end and closer to when rates go up.”

Here’s what Fed officials have said since the central bank’s last policy-setting meeting in late January:

Fed Chairman Jerome Powell (voter): "If we do see what we believe is likely a transitory increase in inflation, where longer term inflation expectations are broadly stable at levels consistent with our framework and goals, I expect that we will be patient." (Remarks at WSJ Jobs Summit, March 4)

Fed Vice Chairman Richard Clarida (voter): "I am not concerned that there is an inflation response that we’ll see this year that would be inconsistent with our price stability goals." (Remarks at American Chamber of Commerce in Australia, Feb. 24)

Fed Vice Chairman Randal Quarles (voter): No public remarks on inflation.

Fed Governor Lael Brainard (voter): "We could see transitory inflationary pressures reflecting imbalances if there is a surge of demand that outstrips supply in certain sectors when the economy opens back up. While I will carefully monitor inflation expectations, it will be important to see a sustained improvement in actual inflation to meet our average inflation goal." (Speech at Harvard University, Feb. 24)

Fed Governor Michelle Bowman (voter): "Employment and inflation both remain well below our goals and a full recovery is going to take time." (Remarks to American Bankers Association, Feb. 16)

Fed Governor Christopher Waller (voter): No public remarks on inflation.

Boston Fed President Eric Rosengren: "I don’t expect inflation to be a problem in part because I think the Fed will take care of it if it does become a problem." (Remarks at The Concord Coalition, Feb. 17)

New York Fed President John Williams: "We’re seeing signs of rising inflation expectations back to levels that I think are closer to consistent with our 2% long-run goal." (CNBC interview, Feb. 19)

Philadelphia Fed President Patrick Harker: "As long as inflation rises to 2% — and with our new monetary policy framework, above 2% for a period of time — we're good with that. But we don't want to see inflation running out of control. At this point, I don't see signs of that." (Yahoo Finance interview, March 3)

Cleveland Fed President Loretta Mester: "I think that [higher inflation] will take some time. Of it takes shorter than we think, that's okay because we know how to control inflation on the upside. The challenge over the past decade has been inflation being lower than we want — not higher than we want." (Remarks at Toledo Rotary, Feb. 8)

Richmond Fed President Thomas Barkin (voter): "There are disinflationary pressures that are quite profound and seem to be continuing. As long as you’ve got those disinflationary headwinds, it’s just going to be hard for businesses to believe that you’re going to have the market power to increase prices." (Remarks at Maryland Bankers Association, Feb. 22)

Atlanta Fed President Raphael Bostic (voter): "Our new long-run framework, says explicitly we're going to be willing to let the economy run hot...We will need to really monitor how well we're doing in terms of employment and in terms of inflation." (Yahoo Finance interview, Feb. 4)

Chicago Fed President Charles Evans (voter): "I think the responsiveness of inflation to the economy is not nearly what it used to be. I really want to see above 2% inflation before I even begin to think about getting nervous." (Remarks at CFA Society Chicago, March 3)

St. Louis Fed President James Bullard: "With growth prospects improving and inflation expectations rising, the concordant rise in the 10-year Treasury yield is appropriate." (Remarks at Georgia State University, Feb. 25)

Minneapolis Fed President Neel Kashkari: "More people do want to work, and we shouldn’t raise rates preemptively just because we think inflation might be coming someday down in the future." (Washington Post interview, March 5)

Kansas City Fed President Esther George: "It really is a challenge to, not downplay inflation in my view, but to really understand what is its momentum and what is its persistence in moving prices up." (Remarks at Farm Journal Top Producer Summit, Feb. 25)

Dallas Fed President Robert Kaplan: "In the short-run, or medium-term, I mean over this next year, it wouldn't surprise me if we see more price pressures... But I think the jury's out on how much of this inflation pressure is going to be persistent." (Yahoo Finance interview, Feb. 12)

San Francisco Fed President Mary Daly (voter): "Right now, we don’t see fiscal stimulus boosting inflation in unwelcome ways." (Remarks at Economic Club of New York, March 2)

Brian Cheung is a reporter covering the Fed, economics, and banking for Yahoo Finance. You can follow him on Twitter @bcheungz.

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