The Federal Reserve will be happy to end its two-day policy meeting by making little news, other than promising to continue providing accommodative monetary policy for some time despite a brighter economic outlook.
Markets have begun to look forward to a post-COVID-19-vaccine world, one where a mixture of pent-up consumer demand and more fiscal support in the U.S. fuels a quick economic rebound. Fed Chairman Jerome Powell will likely share some of that optimism at his Jan. 27 news conference, but analysts say the lingering scars of the sharp downturn last year should temper any reflex at the Fed to start removing its supportive policies anytime soon.
The slow start to the rollout of coronavirus vaccines — along with new and more infectious strains of the virus — should add to the Fed's reluctance to ease off its policies. That includes keeping its benchmark federal funds rate at effectively 0% and sticking with its $120 billion-per-month bond purchase program, two efforts aimed at promoting borrowing and consumption by keeping interest rates low.
"Since the worsening pandemic and the slow initial rollout of the vaccines is restraining activity and presenting downside risks to the near-term outlook, we believe Powell will maintain his dovish tone for now," Kathy Bostjancic, chief U.S. financial economist at Oxford Economics, wrote in a note to clients.
He will not have to look far to find recent signs of weakness, either. The most recent U.S. jobs report showed that the country lost 140,000 jobs in December 2020, the first decline since a cratering of 20 million jobs in April 2020.
Still, economists say Congress' approval of a $900 billion fiscal relief package should provide a much-needed boost in the coming weeks to a recovery that was beginning to lose steam. They also anticipate the approval of another fiscal jolt under President Joe Biden's administration, even if the final package ends up being less aggressive than Biden's proposed $1.9 trillion plan.
Bond investors have taken notice, with yields on longer-term U.S. Treasury securities ticking up since Democrats won both houses of Congress and the White House. The yield on the benchmark 10-year Treasury note stood at 1.05% as of Jan. 25 and has stayed above 1% since Democrats took back the U.S. Senate after two run-off elections on Jan. 5.
Bond markets' inflation expectations have also continued rising. The 5-year breakeven inflation rate, a gauge that measures bond markets' expectations of average inflation over the next five years, was at 2.15% as of Jan. 25.
Actual inflation data remains significantly below the Fed's 2% target, however. The Fed's preferred benchmark — the core personal consumption expenditures price index — rose by 1.4% year over year in November 2020.
Fed officials expect a rebound in inflation in the next few months, as last spring's massive hit to inflation begins rolling off year-over-year calculations. But they have also made clear that they expect that rebound will be temporary and that inflation will continue to be held down by longer-running structural factors and weak global demand, according to Jim O'Sullivan of TD Securities.
Those structural factors were a key reason behind a historic shift last year in the Fed's monetary policy framework, which will now look to achieve temporary overshoots of 2% inflation to make up for below-target inflation data.
Most Fed officials will likely want to see inflation on a pace to hit 2.5% before opting for their first interest rate hike, which may not be in the cards until the start of 2025, O'Sullivan wrote in a research note. The Fed has also pledged to achieve a "broad-based and inclusive" job market recovery that reaches into minority communities, another factor that should add to the Fed's patience on any policy tightening.
The central bank, however, has signaled that a tapering of its massive bond-buying program would come before a rate hike. The Fed is currently buying $80 billion in Treasury securities and $40 billion in mortgage-backed securities each month. Officials have indicated they will stick to that pace until they have made "substantial further progress" on their dual mandate of maximum employment and stable prices.
A few regional Fed leaders kicked off the year with optimism that the tapering process could start later this year. But Powell batted down those expectations at a Jan. 14 appearance, saying that "now is not the time to be talking about an exit" and that the Fed would communicate any tapering plans "well in advance."
Powell and other Fed leaders are likely worried about a repeat of the 2013 taper tantrum, wrote Seth Carpenter, a former Fed economist who is now chief U.S. economist at UBS. During the taper tantrum, bond markets' fears over the Fed pulling back bond purchases prematurely led to a spike in borrowing costs.
With that experience in mind, the Fed will likely "want to temper medium-term optimism to avoid suggesting that a taper could be coming anytime soon," Carpenter wrote in a note to clients. But Powell will also want to steer clear from emphasizing the "near-term gloom" too much, to avoid any suggestion that the Fed might be preparing to escalate its already large response, Carpenter added.
