The Capital Note

How Much Inflation Will the Fed Tolerate?

Outside the Federal Reserve building in Washington, D.C. (Larry Downing/Reuters)

Welcome to the Capital Note, a newsletter about business, finance, and economics. On the menu today: FOMC meeting, tech stocks tumble, Treasurys climb, and the risks of forward guidance.

FOMC Meeting
Investors are once again testing the adage, “Don’t fight the Fed.” The Federal Reserve Open Markets Committee (FOMC), which is holding a press conference this afternoon, has for months signaled that it does not intend to raise interest rates until at least 2024. But since February, yields on U.S. Treasury notes have moved up, implying three rate hikes in 2023.

Since the 2008 financial crisis, investors anticipating monetary tightening have generally been clobbered, and while bets against long-dated Treasuries have paid off for some in recent months, recent history indicates that the Fed wins battles with Wall Street. Today’s press conference is unlikely to reveal anything new in the way of policy, but it will indicate the extent to which the Fed is willing to double down on its forward guidance.

Part of the gulf between FOMC communications and market expectations is a result of the Fed’s new “average inflation targeting” regime, which allows inflation to run above the central bank’s 2 percent target to make up for periods of low price growth. The Fed has yet to clarify just what it means by “average,” and bond markets indicate that a persistent overshoot of the target will lead to a rate hike.

Powell has also emphasized that the Fed will be less proactive and more reactive, waiting to adjust policy until economic data reach the mandate of full employment. That leaves investors guessing what employment rate the Fed will consider satisfactory, a task made doubly difficult by Powell’s recent focus on unemployment rates for specific demographics, such as minority groups.

Bloomberg’s Conor Sen suggests the FOMC should tie its forward guidance on interest rates to an optimistic economic outlook:

The best way for the Fed to show commitment to its new framework is in the Summary of Economic Projections it will release along with its policy statement on Wednesday. A cautious outlook that emphasizes the risks and uncertainties surrounding economic reopening wouldn’t be surprising.

But instead, the Fed should be every bit as optimistic about growth as the market has been, while still sticking to its script on the timing of any rate increase. Only by meeting or exceeding the optimism of investors while retaining its current policy stance can Powell persuade investors that he’s determined to let the economy run hot in order to achieve the Fed’s objectives.

Sen’s argument is that overly cautious economic projections raise questions as to the Fed’s reaction function. If dovish guidance comes in tandem with weak or uncertain projections, investors are left wondering what happens if GDP growth rebounds and inflation picks up. Outright optimism in the macroeconomic outlook would signal a firmer stance irrespective of the trajectory of the economy.

Even with rosy economic projections, though, confusion around the Fed’s reaction function will persist. For one, it is unclear how rates react to an inflation overshoot after 2023. That explains why there’s been a pickup in longer-dated yields. And, as I mentioned, we don’t yet know what the Fed considers full employment.

While the SEP will indicate just how much inflation the Fed is willing to tolerate, it won’t say much about the yield curve as a whole.

Around the Web
Tech investors are not excited about the FOMC meeting

The broad U.S. stock index slid 0.4%, while the tech-heavy Nasdaq Composite fell 1%. The Dow Jones Industrial Average, meanwhile added 0.2%, or about 74 points.

Shares of big tech stocks helped pull indexes lower, with Apple retreating 2%. Economically sensitive sectors like financials and industrials, meanwhile, gained ground.

Treasury yields continue their upward march

US long-term government bonds endured selling on Wednesday, driving sovereign debt prices lower from Germany to Canada, as markets turned jittery ahead of the conclusion of the Federal Reserve’s latest policy meeting.

The yield on the benchmark 10-year Treasury note, which moves inversely to its price, gained as much as 0.04 percentage points to 1.67 per cent in Wall Street trading. That brought one of world’s most closely watched measures of borrowing costs to its highest level since last February. The yield on 30-year bonds also rose, hitting 2.4 per cent.

Wall Street is going back to work

At JPMorgan Chase & Co., hundreds of interns are set to work in the lender’s New York and London offices in the coming months. Citigroup Inc. is providing workers with rapid Covid tests as it sketches out its plans to safely return people to its buildings. Goldman Sachs Group Inc. has said it hopes to have more employees back by summer.

Random Walk
The Fed has aggressively employed forward guidance to respond to recent recessions. Today’s Random Walk looks at a paper from the Bank of International Settlements highlighting the risks of this strategy:

Forward guidance exposes central banks to various reputation risks. If the public fails to fully understand the conditionality of the guidance and the uncertainty surrounding it, the reputation and credibility of the central bank may be at risk if the guidance is revised frequently and substantially. This is particularly relevant in the case of calendar-based forward guidance, in which deviations in the preannounced timetable may be perceived as reneging on a commitment even if conditions change unexpectedly.

And while state-contingent forward guidance helps to address the risk of an appearance of reneging, it raises others. For example, the announcement of unemployment-based thresholds could be seen as signalling a fundamental shift in monetary strategies and goals. And, as history has shown, the perception that central banks have elevated the role of real variables in monetary policy frameworks can adversely affect a central bank’s credibility for price stability. A widespread perception of this could also create policy uncertainty about what central banks are truly aiming at, which would be counterproductive in the current post-crisis environment. Further, central banks may ex post be seen as having seriously misjudged the outlook, especially if such misjudgments are not widely shared with other forecasters.

That being said, it is important not to underestimate the public’s ability to understand the conditionality of policy rate forward guidance. For example, the publication of projections for policy rate paths seems not to have had any major effect on central banks’ reputation or credibility in New Zealand, Norway, Sweden and the Czech Republic, even though actual interest rates often differed considerably from projections. The deviations have been quite sizeable at times. One possible explanation for the seemingly limited impact of these deviations on credibility is that the central banks have been seen as behaving consistently with their policy objectives given what was known about the economic and financial environment at the time decisions were made.

— D.T.

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