FED’s Observation: Is Hesitating About Inflation Causing Increase in Expectations?

The European Central Bank (ECB) acted at a pace out of character by announcing that it will increase its urgent bond purchases as a move against rising bond yields. ECB President Christine Lagarde said it is “undesirable” for rising interest rates to cause an early tightening in financial conditions.

Bond rates move in opposition to bond prices. Therefore, increasing the amount of purchases made by the central bank, in theory, raises prices and lowers interest rates.

US Treasury bond investors expect a similar sentiment from the FED this week. Inflation concerns are much higher in the US, where the economy is expected to start to recover, with employee vaccinations and a $ 1.9 trillion incentive.

All Eyes Are Now On FED’s Economic Forecasts

However, despite investors testing the Fed’s determination by raising Treasury bond rates, the central bank is unlikely to announce any move that would limit the rise in interest rates. Benchmark Treasury bond yield reached 1.63% on Friday, up 10bp compared to the previous day.
This kind of move is in stark contrast to the constant assurance FED Chairman Jerome Powell has given that he is not a cause for concern and that the central bank is focused on reaching out.
In this case, investors will take a closer look at what will be released Wednesday after the two-day meeting of the Federal Open Market Committee (FOMC).

The FED publishes its economic forecast at one of every two FOMC meetings, and the latest data were published in December. Investors will now look to see if there is an increase in growth or inflation forecasts as the COVID-19 rescue package is signed and implemented.

Investors will also want to see if FED members have adjusted their point graphs to show an increase in interest rates before the end of 2023.

But don’t get too excited. Many analysts do not believe that FOMC members will be completely honest with their interest rate estimates for fear of making the markets even more turbulent.

The most likely outcome is that the FOMC does not make a change in policy and Powell reiterates that sustainable, inclusive employment is a priority and no serious inflation is on the horizon.

In fact, FED members see no problem with a moderate rise in inflation and an accompanying increase in interest rates, as long as expectations remain “ironed”.

The problem is right here. The FED has thought seriously about inflation and decided that it no longer needs to worry too much about it. But the problem is that although the FED can change its policies, it cannot change the laws of nature in finance.

The 2008-09 financial crisis seemed to have eradicated inflation, but the extraordinary monetary and fiscal measures now implemented in the name of combating the epidemic have revealed a unique situation in which some feared it would rekindle inflation.

Treasury Secretary Janet Yellen, a former Fed President and a successful economist, said on Sunday that inflation is likely to rise with the stimulus, but she believes this will be a temporary situation and the risk of a rapid rise in prices is very low.

Other economists aren’t as sure as Yellen. Former Treasury Secretary Larry Summers warned that inflation expectations could rise sharply with unprecedented stimulus.
Harvard economist Robert Barro fears that the nominal capital built by former FED President Paul Volcker, by lowering inflation through brutal rate hikes in the early 1980s, will be wasted by “weak policymakers.”
10-Year Head-to-Head Inflation Rate

10-Year Head-to-Head Inflation Rate

Kaynak: St. Louis FED

A standard market measure of inflation expectations — the 10-year breakeven rate from inflation-protected Treasury bonds — approached 2.3% last week, the highest in nearly eight years.

The determination of the FED to make important moves if necessary anchors inflation expectations, and concerns about the weakening of this determination and the loosening of iron are on the rise.

Powell reassures Wednesday that the FED will intervene carefully and swiftly if expectations rise. Keeping silent about inflation will tell a lot.

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