Chairman of the Federal Reserve Jerome Powell listens during a Senate Banking Committee hearing on “The Quarterly CARES Act Report to Congress” on Capitol Hill in Washington, U.S., December 1, 2020.
Susan Walsh | Reuters
As the economy booms over the next couple of months, the Fed will have a more difficult time defending its super-easy policies.
Economists expect the second quarter to grow by more than 9%, and the monthly jobs reports are likely to show very strong hiring, with job growth averaging more than1 million new payrolls in each of the next several months.
Already the reaction to March’s surprisingly strong jobs report could be a sign of more to come. March’s report Friday showed the surge in new jobs to 916,000, nearly 250,000 more than expected.
After the data was released Friday, the fed funds futures market began to immediately bring forward expectations for a Fed rate hike to December 2022, from the spring of 2023.
“Friday took us to the other side,” said Peter Boockvar, chief investment strategist at Bleakley Advisory Group. “That’s a full year ahead of where the [Fed forecasts] are telling us the majority of the committee is. They’re still looking at 2024 as their first hike.”
Jim Caron, head of global macro strategy at Morgan Stanley Investment Management, said the Fed is facing one of its toughest tests ever.
Last year, the Fed moved to a new inflation policy, where it would tolerate a range for inflation, on both sides of its target of 2%. The Fed will have to defend its zero interest rate policy and its bond purchasing program as a whole wave of data shows a big jump in economic activity and inflation, which could rise well above 2%, at least temporarily.
Because of the economic shutdowns a year ago, inflation this spring could look hot when compared to the low base of a year ago. Fed Chairman Jerome Powell has said the Fed expects a transient increase in inflation, but some in the market expect a higher level of inflation based on surging demand and and also government stimulus.
“They’re going to go through the gauntlet now. They’re going to go though the toughest part of the gauntlet in April and May,” Caron said. “The data is going to be good. This quarter is going to test their credibility …The second quarter is going to be plus 10% growth and inflation is going to get to core PCE around 2.5%, and they’re going to say, ‘this is transitory.'”
As the data gets better, the Fed’s job will become even harder. The consumer price index is released next week, and it could start to show signs of inflation just because of the comparisons with last March’s decrease in many prices. CPI for February was up 1.7%, the biggest gain in a year.
“They want a full recovery and they will wait it out. That said, the concern is not just what we’re getting in stimulus but whether you get additional stimulus in infrastructure,” said Grant Thornton chief economist Diane Swonk. “The Fed is not going to put that in their forecast until they see it, but the bond market is front-running that.”
Swonk said the inflation data could be very strong with CPI over 3%, and some components within the data spiking. “Used vehicles are going to be up 35% versus year ago because they plummeted a year ago. There’s a potential for some really weird numbers in there,” she said.
Treasury yields have rising on economic optimism, expectations for inflation, and stimulus spending that should increase Treasury supply and boost the economy. Congress recently approved a $1.9 trillion stimulus package, and some of the money has made its way into the economy. President Joe Biden last week unveiled a $2 trillion infrastructure plan.
The benchmark 10-year Treasury, which influences mortgages and other loans, was at 1.71% Monday. It gained about 90 basis points in the first quarter.
The 2-year yield has also been rising recently. After the jobs report, it rose to near 0.18%, its highest level in 14 months. Yields move opposite price, and the 2-year yield is more reflective of the Fed’s interest rate intentions than the 10-year. The 2-year was at 0.16%
Caron said the economic data is going to keep getting better for awhile, as states reopen and vaccinations surge. The market could also keep pressing the Fed, but he expects Fed officials to hold to 2024 for the first rate hike.
“This is a policy driven market and policy makers are super important right now,” he said.
Michael Schumacher, director of rates at Wells Fargo, said the market is pricing in more than three hikes in total for 2023.
“The market is pricing a lot of rate hikes,” said Schumacher. He said the market is having difficulty working through the strong data and expectations for even more over the next several months.
“I suspect the market keeps throwing more rate hikes in. The question then is, what does Powell do?” he said. “The point is we can see the numbers but nobody’s been down this path before. The reaction function is new. This idea of targeting inflation is new. What happens if inflation goes significantly above 2%? The Fed is going to get a lot of heat.”
Before the Fed even considers raising interest rates, it is expected to pare back the $120 billion a month in Treasurys and mortgage securities it is buying.
Mark Cabana, head of short U.S. rates strategy at Bank of America, expects the Fed to signal its intentions about tapering back the program soon and could begin to slow purchases in December, just about a year before it should start to raise interest rates.
“There is a real chance the Fed will start to change its tune and signal real progress in the near future,” Cabana said. “The minutes this week will be interesting in that regard. The guidance, ‘substantial further progress’ has been very vague …They need to start setting the stage soon.”
The Fed releases minutes of its last meeting on Wednesday afternoon. The Fed has stated it will continue its asset purchases at its current pace until it sees progress in the economy and job market.
Cabana said the Fed should complete paring back its asset purchases before it raises interest rates, and he believes the market is too aggressive in the timing of the first rate. But he expects the Fed to hike aggressively once it starts.
Cabana said previous minutes already have shown a divided view inside the Fed, and that may increase as stronger economic numbers roll out. For instance, Dallas Fed President Robert Kaplan identified himself as one of the officials on the Fed’s anonymous forecast who wants an earlier than consensus rate hike, in 2022 in his case.
“The core dominates …There’s basically two camps, and the core is most important,” said Cabana. But he expects the discontent to get louder.
Grant Thornton’s Swonk also expects the voices of dissenters to increase as the economic data improves. “The [regional Fed] presidents are going to get a little more nervous, and that’s going to create dissonance. The message gets harder,” she said.
Boockvar said the market should keep moving ahead of the Fed.
“This is the market saying we’re getting ahead of the Fed,” said Boockvar. “The market is going to drag the Fed into a tightening at some point. Regardless of how dovish the Fed wants to sound, the market is beginning to make adjustments for them.”