The knee-jerk market response that sent the 10-year Treasury yield to 1.54% during Thursday’s speech by Federal Reserve Chairman Jerome Powell implies that the Fed may have to act to dampen yields at the long end of the curve. That may be necessary to reinforce its policy regime of flexible average inflation targeting adopted last year, and to bolster the credibility of its inflation forecast.
From our point of view, this would strongly suggest that Federal Reserve speakers should begin reinforcing Powell’s rhetoric around the use of tools to dampen rates if conditions materially change and the Fed engages in “open-mouth operations” in the coming weeks.
Should the bond market move to further test the central bank’s policy regime and credibility, Fed officials should take this step and act to dampen rates at the long end of the curve.
While the advent of mass vaccinations should be understood as a source of optimism regarding the growth outlook, the economy remains under stress. It has 10 million jobs short of pre-pandemic levels, a real unemployment rate that we think is above 10%, and several million workers who have accepted fewer hours and lower wages as a precondition of remaining employed.
With such strain in the labor markets, the federal funds rate should remain anchored at zero for the foreseeable future.
It is clear that the bond market is pricing in greater inflation on the back of economic reflation this year. Powell’s statement, in our opinion, and the Fed’s inflation targeting policy regime, are predicated on the notion that the structural transformation of the economy over the past two decades has a modest disinflationary bias. That, in turn, gives the monetary and fiscal authorities greater degrees of freedom when it comes to accommodating shocks to the economy.
An inflation expectation of 2.28% does not indicate inflation, hyperinflation, stagflation or dollar debasement. It implies price stability.
The optimal action in the coming weeks or months may be another use of Operation Twist, where the Fed sells Treasurys in its portfolio at the front end of the curve, then takes the proceeds and purchases bonds at the long end of the curve to dampen long-term rates. The purpose would be to address the market moves that are out of line with economic fundamentals without changing the level of Fed holdings of fixed-income securities.
In our estimation, the Powell statement addressed risks to the economic outlook linked to inflation, inflation expectations and the improving economic outlook as the United States emerges from the pandemic-induced recession. We agreed with Powell’s noting that deeply held inflation expectations are not going to change.
As we look at the Fed’s preferred forward-looking metric of inflation expectations, the five-year, five-year forward inflation expectation rate, we note that expectations sit at 2.28%. This does not indicate inflation, hyperinflation, stagflation or dollar debasement. It implies price stability.
Perhaps just as important, Powell went out of his way to reinstate the word “patient” into the discussion on risk linked to inflation. That should be understood to mean that the Fed will not act to pre-empt the nascent economic recovery because of what is widely expected, and what Powell stated, will be a midyear increase in inflation that will be a function of year-ago base effects.
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