When Federal Reserve Chair Jerome Powell steps up to the podium at a virtual press conference on Wednesday to discuss the U.S. central bank’s latest thinking on monetary policy, he’ll be speaking straight to Wall Street.
Yields on U.S. 10-year Treasury notes have surged to about 1.6%, close to a one-year high, in anticipation of faster economic growth as the coronavirus vaccine rollout proceeds. Not only have some $5 trillion in economic stimulus packages swelled the U.S. government’s borrowing to record levels, investors are demanding higher returns from Treasury bonds as compensation for the risk of inflation.
Wall Street analysts are worried the higher bond yields might lead to a correction in prices for riskier assets, from stocks to bitcoin. So the question is whether Powell will allow bond yields to keep rising or if the Fed will step in to ward off any unwanted market reaction. Options range from tightening monetary policy to address the underlying inflation risk, or deploying the central bank’s money-printing machine in new ways to keep yields from rising.
“The markets don’t trust the Fed,” Claudia Sahm, a former Fed economist and current senior fellow at the Jain Family Institute. “It will be a huge test of the Fed into this year and next year. It’s the trickiest monetary policy since the Volcker Rule” deliberations on bank risk-taking that followed the 2008 financial crisis.
Fed officials have used recent speeches to float or tout the possibility of using experimental monetary policies, using names like “Operation Twist” and “yield curve control.”
It’s unlikely Powell will announce any new policy Wednesday, said Steven Kelly, a research associate at the Yale Program on Financial Stability, an initiative focused on understanding financial crises.
“It could be more moderate,” Kelly said. Fed officials could "add language to the statement saying that they’re prepared to use any tools necessary.”
It’s also unlikely the Fed would employ never-before-used monetary policy tools before increasing the size of asset purchases that are already in effect, Sahm said.
For most of the past year the Fed has been buying some $120 billion a month of U.S. Treasury bonds in an effort to stimulate the economy by keeping down yields. Bond prices move in the opposite direction from their yields, so the extra purchasing volume from the Fed helps to push down the yields, which in turn helps keeps interest rates low on everything from business loans to 30-year home mortgages.
The Fed might shift some its Treasury purchases to more heavily weight its bond purchases toward longer-term maturities, said Kathy Bostjancic, chief U.S. financial economist for Oxford Economics.
“As of December, when I calculated the average maturity of [the Fed's] purchases, it was 7.4 years,” Bostjancic said. “So they could start to shift that outward towards 10-year, 20-year, 30-year bond purchases.”
Oxford Economics revised its GDP forecast for the U.S. from 3.2% this year to 7%, projecting the U.S. would beat China in economic growth, Bostjancic added.
Powell might have to address how prices and markets might react as the economy reheats when people start getting out and about, and when jobs are created, increasing competition for workers and driving up wages.
According to Sahm, these “pent-up demand” narratives are being “overplayed” by market commentators who see an elevated inflation risk.
She expects Federal Reserve officials’ median estimates for future inflation – contained in a revised “Summary of Economics Projections” expected to be published Wednesday – will likely come in above 2% but well below 3%.
That’s far from the double-digit inflation levels witnessed in the late 1960s and early 1970s of which some analysts have warned.
The Fed has "commented that certain parts of the market are risky and have elevated valuation such as the equity market and also commercial real estate,” Bostjancic said. “I think [the central bank] wouldn't target that. They're not going to try to [target] cryptocurrencies. They probably wouldn't mind, though, if we had a moderate rise in long-term [bond] rates that was somewhat of a natural break for some of these riskier assets.”