The "New Fed News Agency" looks forward to this week's FOMC meeting! Interest rate policy, QT reduction, inflation, all said!

Wall Street Sights

2024-05-01 03:47Posted on the official account of Shanghai Wall Street News

Fed officials began their two-day FOMC policy meeting on Tuesday. Nick Timiraos, a well-known financial journalist known as the "New Fed News Agency", began his latest conference preview article by quoting the old Chinese proverb "rule by doing nothing", which may summarize the Fed's latest interest rate policy approach.

The Fed is expected to keep its benchmark federal funds rate unchanged at its highest level in more than 20 years, or about 5.3%, Timiraos said. He noted that higher-than-expected inflation in the United States in the first three months of this year may have delayed the timing of the Fed's interest rate cuts in the foreseeable future. Fed officials are likely to stress that they are prepared to keep rates unchanged for longer than previously expected, which would put them at a level that most officials expect to have a significant dampening effect on U.S. economic activity.

The Fed will not release new economic projections at this meeting, and its policy statement is expected to change only slightly, so Fed Chair Powell's press conference on Wednesday will be in focus. Here are a few points that Timiraos believes need to be highly focused.

Inflation progress has suffered a setback

Since the March meeting, the U.S. economy has continued to show strong momentum. But inflation has been disappointing. Previously, a series of cooling inflation data in the second half of 2023 had sparked optimism, with the Fed generally believing that it would be able to cut interest rates.

Powell said in March that strong price pressures in January were just a "bump" in the road to declining inflation. However, the subsequent February and March data, while not as hot as January, remained strong, shattering this optimism. The data raised the outlook that US inflation could eventually hover around 3%, while the Fed's inflation target remains at 2% for the long term.

Powell is likely to repeat his message two weeks ago at his press conference this week, when he said that the recent data clearly does not give us greater confidence that inflation will continue to fall to 2%, and on the contrary, the data suggests that it may take longer than expected to achieve that target.

The focus of this meeting will be on how Powell describes the outlook for interest rates. While most Wall Street strategists believe that the Fed is still likely to cut rates once or twice later this year, such a rebalancing without clear evidence of weakness in the U.S. economy is still more variable than it was just a few weeks ago. Some even believe that the Fed may not cut rates at all.

The Fed's interest rate outlook depends on its inflation forecasts, and the latest data raises two possibilities:

One is that the Fed's previous projections of inflation remain applicable, i.e., inflation continues to move low but unevenly and bumpy, only more volatile. In this case, interest rates will still be cut this year, although they may be delayed and the pace of rate cuts will be slowed. The second possibility is that inflation did not "bumpy" all the way to 2%, but fell into a level close to 3%. If there is no evidence that the US economy is slowing more significantly, then the case for a rate cut may be removed altogether.

Interest rate policy remains at an appropriate level

Powell is likely to admit that officials are less confident about when and how big they are going to cut rates. In March, the vast majority of officials expected two or more rate cuts this year, with a slight majority expecting at least three.

Although officials will not submit new economic projections this week, Powell will still have a chance to reconfirm those old forecasts from the previous meeting or declare them obsolete at other meetings that have not been released in the past. This Wednesday's meeting is more likely to produce the latter, that is, the March forecast is outdated.

At the same time, Fed officials said they were generally satisfied with their current policy stance. This means that it is unlikely that the Fed will shift in a hawkish direction and consider raising interest rates. Powell said in mid-April that "policy is in the right position to address the risks we face." If inflation continues to strengthen, the Fed will keep interest rates at current levels for longer. ”

As financial market participants expect a smaller rate cut, yields on long-term Treasury bonds will rise. In effect, this achieves the tightening of financial conditions that the Fed sought when it raised interest rates last year. The rising yield curve of US Treasury bonds should eventually hit asset values, including equities, and slow economic growth momentum.

The risk of a hawkish turn is low

At the moment, the difficulties Fed officials face in communicating their outlook boil down to the "what if/then" conditional statements they make, which are based on a set of outcomes. When the U.S. economy behaves differently than Fed officials expected, their past statements may no longer be valid.

As a result, it may be difficult for Powell to rule out any additional rate hikes, and even if Fed officials take a substantial step in this direction, it may be premature.

However, for the time being, a hawkish shift is unlikely, suggesting that a rate hike is more likely than a cut. Any such shift is likely to unfold gradually over an extended period of time. This will require some new severe supply shocks, such as a significant rise in commodity prices, signs of another acceleration in wage growth, and evidence that the public expects higher inflation to continue for an extended period of time to come.

A key indicator of wage growth released on Tuesday suggested that the continued cooling of U.S. wage growth last year may have stalled in the first quarter. Compensation for private sector workers rose 4.1 percent year-on-year in the first quarter, essentially unchanged from the fourth quarter of last year, the Labor Department said.

Signs that wage pressures are easing are important factors in easing concerns among some Fed officials about persistent services inflation. Further evidence of an acceleration in wage growth in the coming months could be unsettling for Fed officials.

Federal Reserve Balance Sheet

Fed officials have previously said they may soon announce a tapering of quantitative tightening (QT). This has led analysts to expect the Fed to formally announce a tapering of QT at this week's meeting, while others believe that the Fed may announce it at its June meeting.

The Fed officially began quantitative tightening in June 2022. Currently, up to $60 billion in U.S. Treasury bonds and up to $35 billion in mortgage bonds are allowed to mature each month without buying new securities.

At their March meeting, Fed officials appeared to have agreed on a plan to "roughly halve" the pace of asset reduction. Since high interest rates have kept the reduction in mortgage bonds at a lower level, officials will not change the QT for this part, which is aimed at the Treasury component, lowering the monthly tapering cap.

The latest changes have nothing to do with interest rate policy and are intended to avoid the overnight lending market chaos that occurred five years ago.

The Fed's balance sheet reduction is also gradually depleting bank deposits in the financial system that are deposited with the Fed, known as reserves. Fed officials don't know when reserves will become scarce enough to push up yields in the interbank lending market. As a result, many officials believe that slowing down the process is preferable now, as it could allow the Fed's asset portfolio reduction to continue for a longer period of time without the risk of the market turmoil that occurred in 2019.