This week’s Federal Reserve meeting could be the last before the central bank sets the stage for how and when it will start to roll back the extraordinary easing policies it adopted to fight the pandemic.
Fed officials are not expected to take any action as the meeting closes Wednesday. Nevertheless, they are expected to acknowledge signs of positive momentum in the economy when their statement is released at the end of their two-day meeting.
The central bank has now been operating on high alert for 14 months, starting when officials quickly slashed their benchmark overnight lending rate to zero. The Fed also instituted a series of programs to keep markets liquid and credit flowing as the pandemic shut down the economy.
The economy is storming back, bolstered by fiscal and economic policy, as well as the growing numbers of people vaccinated against Covid-19. First-quarter gross domestic product, which will be reported on Thursday, is expected to show the economy grew by 6.5%. Second-quarter growth could be closer to 10%.
“We’re not expecting changes in the statement or much change in Chair [Jerome] Powell’s posture in the media,” said Tony Crescenzi, Pimco executive vice president, market strategist and portfolio manager.
“We’re not expecting the Fed to give any indication until summer as to what it might do with respect to its balance sheet,” he said. “It may start dropping hints around that time.”
The Fed has taken unprecedented measures to stave off a worse economic crash and succeeded in keeping financial markets functioning. As a result, its balance sheet has ballooned to $7.9 trillion.
The process of moving away from these policies is expected to be slow and deliberate.
“They’re running out of time,” said Mark Zandi, chief economist at Moody’s Analytics. “The next time they meet they will need to acknowledge how strong the economy is … They need to start tapering [asset purchases]….The economy is busting out all over. We’re going to see lots of jobs, much lower unemployment. There’s base effects on inflation, but that’s going to be hard to ignore.”
Bond buying unwind
Bond strategists have been focused on when the Fed would start to unwind the $120 billion a month minimum in asset purchases, often termed quantitative easing, or QE.
At some point, central bank officials are expected to discuss their intentions to slow the purchases, and then begin the process of cutting back months later. Powell has said the central bank will slow the purchases when it sees “substantial further progress” in the economy.
“The key focus will be on the description and characterization of ‘substantial further progress,'” said Mark Cabana, head of U.S. short rates strategy at Bank of America. “We don’t think we’re going to get much clarity there. We think this is going to be a largely ‘wait and see’ type of Fed. They will sound more optimistic as they have, Powell in particular will.”
Cabana said the market is waiting for details on what the Fed would see as further substantial progress. He said Powell is likely to discuss the bond purchase program at the June meeting and continue to talk about it before moving to pare it back early next year. The Fed is buying at least $80 billion in Treasurys and $40 billion in mortgage-backed securities each month.
“If Powell surprises and suggests we’re seeing some signs of further progress and depending how confident he sounds, then rates could rise on the back of that and it could signal a potential withdrawal of accommodation, and we don’t think were there yet,” Cabana said.
Cabana said the Fed will have a deliberate process for moving away from QE.
“I think the way we are anticipating this evolution is that it starts with a discussion of how you define substantial further progress. That’s very vague…They probably define it in June, update us in July/August, then signal maybe at Jackson Hole that they are seeing progress,” said Cabana.
The Fed has traditionally met in Jackson Hole, Wyoming at the end of the summer and sometimes uses the meeting to discuss policy changes. Last year’s meeting was virtual due to the pandemic. Cabana said the Fed may then announce at the December meeting that purchases will start to slow in January, 2022.
Cabana said the Fed is expected to complete tapering its bond program before it begins to raise interest rates in late 2023. He said once the Fed does raise interest rates, it may move at a faster rate than markets expect.
The challenge for the Fed is to explain why it is keeping policy so easy when the economy appears to be booming. Cabana said Powell could be asked about the potential froth in markets, from equities to crypto assets.
“Financial conditions are super easy…The Fed seems unfazed by that,” Cabana said. “It’s not like it’s without risks.”
Powell has emphasized that the Fed will be patient so the economy can heal. The Fed has also changed the way it intends to measure success around its dual mandates on inflation and employment.
Employment data has been strong recently and is expected to only get better over the next couple of months.
“We still have a shortfall of not only the 8.4 million jobs and the 1.5 million or more that would have been gained in the normal course of expansion,” Pimco’s Crescenzi said. “And importantly as well when the Federal Reserve will start reducing its accommodation, it wants, as it indicated last August … employment gains to be broad and inclusive.”
That means the Fed could allow the labor market to strengthen, bringing in more workers that could be left behind, before raising interest rates.
As for inflation, prices are rising across the economy and inflation data is expected to show gains that are greater than the Fed’s 2% target this year. Due to base effects, inflation should look strong in the next couple of months when compared to the weak period last year. Powell has cautioned that this will be temporary before inflation slows later in the year.
But the Fed has also said it will tolerate higher inflation and it will look at an average, hoping for a period of consistent 2% or better before raising interest rates.
“The Fed has made clear it won’t raise interest rates until the inflation rate has been at its target for a year or has moved above its target for some time,” Crescenzi said. “By this definition, it doesn’t look like the Fed will raise rates until 2023 or early 2024.”
The consumer price index, which increased 2.6% from a year ago in March, is expected to rise above 3%. “This will be the message…The Federal Reserve will look through it and so will market participants,” said Crescenzi.
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