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The Fed must walk a fine line Wednesday as financial markets hang in the balance

Federal Reserve Jerome Powell testifies 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

A resurgent economy, percolating inflation and a stock market ripping higher don’t seem to make much of a recipe for easy monetary policy.

But that’s the position in which the Federal Reserve finds itself.

The challenge for the central bank this week will be to explain that position to investors and assure them that even if the status quo remains, that won’t provoke policymakers to change course, nor should they.

“The basic line is, ‘Everything looks a little better, but there’s still a lot of uncertainty and we’re not going to do anything soon.’ I’m sure we’ll hear that,” said Bill English, former head of the Fed’s Division of Monetary Affairs and now a finance professor at the Yale School of Management.

“They do want to suggest that things are better,” he said. “On the other hand, they don’t want to suggest that they’re going to change policy anytime soon. So it’s a tricky communication.”

The Federal Open Market Committee, which sets monetary policy, meets Tuesday and Wednesday, followed by a news conference from Fed Chairman Jerome Powell.

No one is expecting broad-stroke changes. Short-term borrowing rates will remain near zero, and the Fed will continue buying at least $120 billion a month in bonds to keep markets flowing and financial conditions loose.

There will be much for investors to chew on from this meeting.

Economic projections due

Eddie Rodriguez, who works for the City of Hialeah, hands out unemployment applications to people in their vehicles on April 8, 2020 in Hialeah, Florida.

Joe Raedle | Getty Images News | Getty Images

For one, individual members will update their forecasts for gross domestic product, unemployment and inflation.

They last submitted estimates in December, before Congress approved two stimulus packages totaling nearly $3 trillion and before a Covid-19 vaccine rollout that is seeing 2.4 million Americans inoculated every day.

Goldman Sachs recently raised its GDP forecast to 7% for the full year and also sees unemployment falling more rapidly than expected while inflationary pressures heat up.

By contrast, the Fed’s Summary of Economic Projections in December indicated a median estimate of just 4.2% for GDP, along with an unemployment rate projection of 5% and core inflation running around 1.8%.

Those numbers are likely to see “material upward revisions,” according to Bank of America.

The GDP figure could be raised by “at least” 1.5 percentage points to a range of 5.7% to 6%, while unemployment could be taken down to 4.8% and inflation raised to the Fed’s 2% target, Bank of America estimated.

Hawkish tilt possible

Jerome Powell, chairman of the U.S. Federal Reserve, speaks during a virtual news conference in Tiskilwa, Illinois, U.S., on Wednesday, Dec. 16, 2020.

Daniel Acker | Bloomberg | Getty Images

They do want to suggest that things are better. On the other hand, they don’t want to suggest that they’re going to change policy anytime soon. So it’s a tricky communication.

Bill English

finance professor at the Yale School of Management

“It’s going to be interesting, because how do you upgrade your GDP forecasts to 7% and your inflation target to 2% and your forecast for unemployment to 5% and then say we’re going to be super easy,” said Kathy Jones, chief fixed income strategist at Charles Schwab. “What they’ll try to emphasize is patience.”

Jones said she doesn’t expect a shift in policy yet, with Powell emphasizing the importance of “as broad and inclusive increase in employment and decrease in unemployment as possible before they even consider raising rates.”

“They’re pretty comfortable waiting it out,” she said.

English, the former Fed official and Yale professor, said Powell will emphasize “uncertainty” despite the progress with the virus and the economy.

“Part of the communication will be ‘our reaction function hasn’t changed. We still want to achieve our objectives, we’re still going to be patient,'” he said. “The most likely outlook is better, but the world is an uncertain place. A lot can happen.”