A teacher and a plumber
The 16-17 March Federal Open Market Committee meeting should reveal that the Federal Reserve still sees no need to hurry tightening, despite the passage of President Biden's USD1.9 trn stimulus package. The central bank's summary of economic projections could show its expected first rate hike brought forward to Q4 2023, but that would still be one year later than is currently being priced in by money markets. A big gap will therefore persist between market and Fed expectations.
Fed chairman Jerome Powell could also use the occasion to put the spotlight on some important market 'plumbing' issues amid rising long-term rates but high liquidity at the short end. A crucial issue is commercial banks' supplementary leverage ratio: a waiver on banks' requirement to respect this ratio ends on 31 March. With fears that debt demand from banks will drop otherwise, markets are clamouring for a partial extension of this waiver. While much less likely, the Fed could also cite technical/plumbing issues to launch 'Operation Twist', increasing the duration of its bond purchases.
The biggest issue for the Fed right now is that the markets do not seem to believe in Powell's signature policy of 'average inflation targeting' and its implication that rate policy will not be tightened for some period. Markets seem to be more inclined to believe that the Fed will be tempted to tighten rates when inflation is in the vicinity of 2%, just like in the 'old days' of Alan Greenspan. In other words, the Fed's new approach to inflation and its monetary stance in general are facing considerable credibility challenges.
As a reminder, the 'new' Fed strategy allows for increased tolerance of higher inflation, partially as a trade-off for meeting other goals such as improving social cohesion and limiting inequality. The unemployment rate among minorities is a particular focus for the Fed these days. In addition, the Fed may have to take on additional tasks. Just like the Bank of England, it may be called upon to support the 'green transition'.
All these factors, as well as the burden of debt accumulated during the pandemic, mean that the Fed faces more constraints on raising rates than the market currently perceives. We are not in the 1990s anymore. Powell will have to do more to 'educate' the markets on this point on 17 March.
We continue to believe that it is premature for the market to be pricing in a first hike of the fed funds rate for late 2022. Like the Fed, we think a rise in inflation this spring is likely to be temporary. But the bond market could continue to test Powell if he does not provide a strong defence of the Fed's 'average inflation' strategy and explain what it means in practice.