"New Federal Reserve News Agency" previews this week's FOMC meeting! Interest rate policy, QT reduction, inflation, all covered!

Federal Reserve officials began a two-day FOMC policy meeting this Tuesday. Renowned financial journalist Nick Timiraos, known as the "New Federal Reserve News Agency," quoted an ancient Chinese proverb "governing by inaction" at the beginning of his latest preview article on the meeting, suggesting that this may summarize the Federal Reserve's latest interest rate policy.

Timiraos indicated that the Federal Reserve is expected to keep the benchmark federal funds rate unchanged at around 5.3%, the highest level in over 20 years. He pointed out that higher-than-expected U.S. inflation in the first three months of this year may delay the timeline for future interest rate cuts by the Federal Reserve. Federal Reserve officials may emphasize their readiness to maintain rates unchanged for a longer period than previously expected, which can keep rates at a level that most officials believe would have a significant restraining effect on U.S. economic activity.

The Federal Reserve will not release new economic forecasts at this meeting, and the policy statement is expected to have only minor changes, making Wednesday's press conference by Federal Reserve Chairman Powell the focal point. Here are a few key points that Timiraos believes need close attention.

Setback in Inflation Progress

Since the March meeting, the U.S. economy has continued to show strong momentum. However, the performance of inflation has been disappointing. Previously, a series of data showing a cooling of inflation in the second half of 2023 had sparked optimism, with the widespread belief that the Federal Reserve would be able to cut rates.

Powell stated in March that the strong price pressures in January were just a "bump" on the road to lower inflation. However, the data in February and March, while not as hot as January, remained strong, dispelling this optimism. The data raised the prospect that U.S. inflation could ultimately hover around 3%, while the Federal Reserve's inflation target is to sustain at 2% in the long term.

Powell may reiterate his message from two weeks ago at this week's press conference, where he indicated that recent data has not given us greater confidence that inflation will continue to decline to 2%. Instead, the data suggests that achieving this goal may take longer than expected.

The focus of this meeting will be how Powell describes the interest rate outlook. Although most Wall Street strategists still believe that the Federal Reserve may cut rates once or twice later this year, making such adjustments without clear evidence of U.S. economic weakness remains more uncertain compared to just a few weeks ago. Some even believe that the Federal Reserve may not cut rates at all.

The Federal Reserve's interest rate outlook depends on its inflation forecast, and the latest data presents two possibilities:

• The Federal Reserve's previous inflation forecast still applies, meaning that inflation continues to trend lower but unevenly and with more volatility. In this scenario, rate cuts are still expected this year, but they may be delayed and the pace of cuts may slow down.
• The second possibility is that inflation does not steadily reach 2%, but instead hovers around close to 3%. If there is no evidence that the U.S. economy is significantly slowing down, the rationale for rate cuts may be completely eliminated

Interest rate policy remains appropriate

Powell may acknowledge that officials have less confidence in when and to what extent to cut interest rates than before. In March of this year, the vast majority of officials expected two or more rate cuts this year, with a slight majority expecting at least three rate cuts.

Although officials will not submit new economic forecasts this week, in other meetings where economic forecasts were not disclosed, Powell still has the opportunity to reaffirm those old forecasts from the last meeting or declare them outdated. This Wednesday's meeting is more likely to result in the latter, that is, the March forecasts are outdated.

At the same time, Federal Reserve officials have indicated that they are generally satisfied with the current policy stance. This means that the Fed is unlikely to shift towards a hawkish direction and consider the possibility of raising interest rates. Powell stated in mid-April, "Policy is in the right place to address the risks we face. If inflation continues to strengthen, the Fed will keep rates at their current level for a longer period."

As market participants expect smaller rate cuts, the yield on long-term U.S. Treasuries will rise. In fact, this achieves the tightening of financial conditions sought by the Fed when it raised rates last year. The rise in U.S. Treasury yields should ultimately undermine asset values, including stocks, and slow down economic growth momentum.

Low risk of hawkish shift

Currently, the difficulty Federal Reserve officials face in conveying their outlook is summed up in the conditional statements they make, which are based on a set of outcomes. When the U.S. economy performs differently from what Fed officials expected, their past statements may no longer be valid.

Therefore, Powell may find it difficult to rule out any additional rate hikes, even though it may still be too early for Fed officials to take a substantial step in that direction.

However, for the time being, a hawkish shift is unlikely, implying that the possibility of rate hikes is greater than rate cuts. Any such shift is likely to unfold gradually over a longer period. This would require some new severe supply shocks, such as: a significant rise in commodity prices, signs of wage growth accelerating again, and evidence that public expectations of higher inflation levels in the foreseeable future will continue.

A key wage growth indicator released on Tuesday showed that the continuous cooling of U.S. wage growth last year may have stalled in the first quarter. The U.S. Labor Department reported that wages for private-sector workers grew by 4.1% year-on-year in the first quarter, basically flat compared to the fourth quarter of last year.

Signs of easing wage pressures are a key factor in alleviating some Fed officials' concerns about persistent service sector inflation. Further evidence of accelerating wage growth in the coming months could unsettle Fed officials.

Federal Reserve balance sheet

Federal Reserve officials have previously indicated that they may soon announce a reduction in quantitative tightening (QT). This has led analysts to expect the Fed to formally announce the reduction of the QT plan at this week's meeting, with some believing that the Fed may announce it at the June meeting as well The Federal Reserve officially began quantitative tightening in June 2022. Currently, a maximum of $60 billion in U.S. Treasury securities and up to $35 billion in mortgage-backed securities are allowed to mature each month without new securities being purchased.

At the meeting in March this year, Federal Reserve officials seemed to have reached a plan to "roughly halve" the pace of asset reduction. Due to the low level of reduction in mortgage-backed securities due to high interest rates, officials will not change this part of QT, but will reduce QT for U.S. Treasuries by lowering the monthly reduction cap.

The latest changes are unrelated to interest rate policy and are aimed at avoiding the overnight lending market turmoil that occurred five years ago.

The Federal Reserve's reduction of its balance sheet is also gradually depleting bank reserves held at the Federal Reserve, known as reserve deposits. Federal Reserve officials do not know when reserve deposits will become scarce enough to push up yields in the interbank lending market. Therefore, many officials believe that slowing down this process now is preferable, as it may allow the reduction of the Federal Reserve's asset portfolio to continue for a longer period without facing the risk of market turmoil like that of 2019