"New Fed News Agency": The Fed intentionally hints that interest rates will be "higher and longer"

Nick Timiraos, a correspondent from the New Fed News Agency, wrote in his latest report that an old Chinese saying called "rule by inaction" can be used to summarize the Fed's latest interest rate policy. At the two-day policy meeting that began Tuesday, North American Eastern Time, Fed officials will keep the benchmark federal funds rate untouched at around 5.3%, the highest in the last couple decades. Timiraos said that because of higher-than-expected inflation in the first three months of this year, the Fed may postpone rate cuts in the foreseeable future. Officials are likely to stress their readiness to keep interest rates stable, and most officials expect this level of interest rate to have a sufficient dampening effect on economic activity and last longer than previously expected. Now that there are no new economic forecasts for this meeting, there will be no changes to the Fed's policy statement, and the press conference of Fed Chairman Powell will be the main event. The anti-inflation process has been frustrated

Since the March interest rate meeting, the US economy has continued to show strong momentum, but the progress of US inflation this year has been disappointing after a series of cooling data in the second half of 2023 sparked optimism that the Fed may cut interest rates. In March, Powell said strong price pressures that emerged in January were a big obstacle on the Fed's path to lower inflation. Solid inflation data in February and March, even if not as hot as January, have dashed their previous optimism and raised the prospect that inflation could stabilize at close to 3%, compared with the Fed's target of 2%.

Timiraos believes Powell is likely to repeat the message he sent two weeks ago, when he said recent data "clearly does not give us greater confidence" that inflation will continue to fall to 2%, "rather, it suggests that it may take longer than expected to get there."

Timiraos also noted that the focus of this meeting will be on how Powell describes the outlook for interest rates. While most Wall Street strategists believe one or two rate cuts are still possible later this year, the prospect of rate cuts is still less certain than it was a few weeks ago in the absence of clear signs of economic weakness. Some believe 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 expectations that inflation will continue to move lower, but in an uneven and "bumpy" way, remain unchanged, but there will be bigger bumps in the road. In this scenario, the Fed could still cut rates this year, albeit at a later and slower pace. The second possibility is that inflation is not on a "rocky" path to 2% but is stuck near 3%. Without evidence that the economy is slowing significantly, expectations of a Fed rate cut this year could be completely dashed. The risk of the Fed turning hawkish is low

Timiraos believes that Powell may also admit that officials are not so firm on when and by how much to cut rates. In March, most officials expected two or more rate cuts this year, and most expected at least three rate cuts. Although officials will not submit new forecasts this week, at other meetings where forecasts are not submitted, Powell will use the opportunity to reiterate previous forecasts or declare them outdated. The latter is more likely to happen at this meeting. At the same time, Fed officials said they are generally satisfied with their current stance. This makes it unlikely that the Fed will turn to a hawkish stance of raising interest rates. Powell said on April 16 that "policy is ready to address the risks we face." He said that if inflation continues to strengthen, the Fed will keep interest rates at current levels for longer.

As financial market participants expect smaller rate cuts, long-term Treasury yields will rise. In effect, this achieves the kind of tightening in the financial environment that Fed officials sought when they raised interest rates last year. The overall rise in the Treasury yield curve should eventually hit asset values, including stocks, and slow economic growth momentum.

Subadra Rajappa, head of U.S. interest rate strategy at Societe Generale, said, "If inflation remains firm, this is what the Fed ultimately wants to see."

Fed officials are currently struggling to convey their outlook, which comes down to the so-called "conditional nature" of Fed officials' statements, and their past remarks may no longer be valid when the economy performs beyond officials' expectations.

For this reason, it may be difficult for Powell to rule out the possibility of further rate hikes, although it may be too early for officials to take meaningful action in this direction.

But Timiraos pointed out that it seems unlikely that the Fed will take a hawkish turn at the moment, that is, the possibility of raising interest rates is greater than cutting interest rates. Any such shift would require a combination of factors, such as a new, severe supply shock, such as a sharp rise in commodity prices; signs that wage growth is reaccelerating; and evidence that the public expects inflation to remain elevated going forward.

A key measure of wage growth released Tuesday showed that last year's cooling trend in wage growth may have stalled in the first quarter. The Labor Department said compensation for private-sector workers rose 4.1% in the first quarter from a year earlier, roughly the same as in the fourth quarter.

Signs that wage pressures have been easing are an important factor in alleviating some Fed officials' concerns about rising service-sector inflation, Timiraos said. But if wage growth accelerates in the coming months, that could bother officials.

Balance Shedding Process

Federal Reserve officials have said they may "soon" announce plans to slow the reduction of their $4.5 trillion in Treasury bonds, which are part of the Fed's $7.4 trillion portfolio. That has led analysts to expect the Fed to announce formal plans to slow QT at this week's meeting, though some see that as a possibility at its June meeting.

Each month, Fed officials allow up to $60 billion in Treasury securities and up to $35 billion in mortgage-backed securities to “mature and not roll over.” The process is designed to shrink the Fed’s balance sheet, which peaked at nearly $9 trillion two years ago.

At the March meeting, officials appeared to agree on a plan to “cut in half” the pace of QT. Timiraos noted that the Fed’s adjustments to QT have nothing to do with interest rates but are intended to avoid the chaotic turmoil that occurred in overnight lending markets five years ago.

QT is also draining the financial system of bank deposits held at the Fed, known as reserves. Officials don’t know when reserve reserves will become scarce enough to push up yields in the interbank lending market. Many officials believe that slowing the process now is desirable because it avoids the risk of the kind of market turmoil that occurred in 2019.