Nick Timiraos, a Wall Street Journal reporter with the “New Federal Reserve News Agency,” recently wrote that there is an old Chinese saying “do nothing to fix”, which can summarize the latest interest rate policy of the Federal Reserve.

At a two-day policy meeting beginning Tuesday EST, Fed officials will keep the benchmark federal funds rate unchanged at around 5.3%, the highest level in more than 20 years.

Timiraos said that due to higher than expected inflation in the first three months of this year, the Federal Reserve may postpone predictable interest rate cuts in the future. Officials may emphasize that they are prepared to keep interest rates stable. Most officials expect this level to have a meaningful inhibitory effect on economic activity, and that it will last longer than they had previously anticipated.

Since there are no new economic forecasts at this meeting, there will be no changes to the Federal Reserve's policy statement. Federal Reserve Chairman Powell's press conference will be the main event.

The anti-inflation process has been thwarted

Since the interest rate meeting in March, the US economy has continued to show strong momentum, but US inflation progress this year has been disappointing after a series of cooling data in the second half of 2023 sparked optimism that the Federal Reserve might cut interest rates.

In March of this year, Powell said that the strong price pressure that appeared in January was a major obstacle to the Federal Reserve's path to reducing inflation. Stable inflation data for February and March (if not as hot as January) shattered their previous optimism and suggested that inflation could stabilize at close to 3%, compared with the Federal Reserve's target of 2%.

Timiraos believes Powell may repeat the message he sent two weeks ago, when he said that recent data “clearly does not give us more confidence” that the inflation rate will continue to fall to 2%. “On the contrary, it indicates that it may take longer than expected to achieve this target.”

Timiraos also noted that the focus of this meeting will be how Powell describes interest rate prospects. Although most Wall Street strategists believe it is still possible to cut interest rates once or twice later this year, compared to a few weeks ago, with no obvious signs of economic weakness, the prospects for interest rate cuts are still uncertain. Some people think the Federal Reserve may not cut interest rates at all.

The Fed's interest rate outlook depends on its inflation forecast, and the latest data suggests two possibilities. First, the Fed's expectation that inflation will continue to fall, but the outlook that it will fall in an uneven and “bumpy” manner remains unchanged, but there will be more bumps along the way. Under these circumstances, although it will be delayed and the pace will slow down, the Fed is still likely to cut interest rates this year.

The second possibility is that inflation is not on a “bumpy” path to 2%, but is stuck at a level close to 3%. If there is no evidence that the economy is clearly slowing down, then expectations that the Federal Reserve will cut interest rates during the year may completely fall short.

The risk of the Fed turning hawkish is low

Timiraos believes that Powell may also admit that officials are not so firm about when and how much interest rate cuts will be made. In March of this year, most officials predicted that interest rates would be cut twice or more when this year, and most officials expected to cut interest rates at least three times.

Although officials will not submit new predictions this week, Powell will use this opportunity to re-emphasize previous predictions or announce that they are out of date at other meetings where predictions have not been submitted. And at this meeting, the latter is more likely to happen.

Meanwhile, Federal Reserve officials said they are generally satisfied with the current position. This makes it unlikely that the Federal Reserve will shift to a hawkish stance of raising interest rates.

Powell said on April 16, “Policies are ready to deal with the risks we face.” He said that if inflation continues to strengthen, the Federal Reserve will keep interest rates at current levels for a longer period of time.

As financial market participants expect interest rate cuts to be smaller, long-term US bond yields will rise. In fact, this has achieved the kind of austerity that Federal Reserve officials sought when they raised interest rates last year in the financial environment. The overall rise in the US bond yield curve should eventually hurt the value of assets, including stocks, and slow down the economic growth momentum.

Subadra Rajappa, head of US interest rate strategy at Société Générale, said, “If inflation remains strong, this is what the Federal Reserve ultimately wants to see.”

It is currently difficult for Federal Reserve officials to communicate their prospects. It boils down to the so-called “conditional nature” of the statement made by the Federal Reserve officials. When economic performance exceeds the expectations of officials, their past remarks may no longer be valid.

For this reason, it may be difficult for Powell to rule out the possibility of further rate hikes, although it may be too early for officials to take meaningful action in this direction.

However, Timiraos pointed out that currently it seems unlikely that the Federal Reserve will take a hawkish turn, that is, the possibility of raising interest rates is greater than cutting interest rates. Any such transformation requires a combination of factors, such as a new, severe supply shock, such as a sharp rise in commodity prices; signs that wage growth is accelerating again; and evidence that the public expects inflation to continue to rise in the future.

A key indicator for measuring wage growth released on Tuesday showed that the trend of wage growth that continued to cool down last year may have stalled in the first quarter. The US Department of Labor said that the remuneration of private sector employees increased by 4.1% in the first quarter compared to the same period last year, which is basically the same as in the fourth quarter of last year.

Timiraos said that wage pressure has been showing signs of easing is an important factor in mitigating the concerns of some Federal Reserve officials about rising inflation in the service sector. But if wage growth accelerates in the next few months, this could be troubling for officials.

Abbreviation process

Federal Reserve officials have said they may “soon” announce plans to slow down their 4.5 trillion US debt reduction. These US bonds are part of the Federal Reserve's $7.4 trillion asset portfolio. This has led analysts to expect that the Federal Reserve will announce an official plan to slow down QT at this week's meeting, but some believe that this situation may occur at the June meeting.

Every month, Federal Reserve officials allow up to $60 billion in treasury bonds and up to $35 billion in mortgage-backed securities to “not expire.” This process aims to reduce the Federal Reserve's balance sheet. Two years ago, the Federal Reserve's balance sheet peaked at nearly $9 trillion.

At the March meeting, officials seemed to agree on a plan to “cut” the speed of QT in half. Timiraos pointed out that the Fed's adjustment to QT had nothing to do with interest rates, but rather to avoid the chaos and turmoil that occurred in the overnight loan market five years ago.

QT is also exhausting bank deposits held with the Federal Reserve in the financial system; these deposits are known as reserves. Officials don't know when reserve reserves will become scarce enough to boost the yield in the interbank loan market. Many officials believe it is advisable to slow down this process now, as it will avoid the risk of market turbulence like the one that occurred in 2019.

Editor/Somer