Highlights From the March FOMC Minutes

On Wednesday the Federal Reserve released the minutes of their March meeting. At the time I said it was the most hotly anticipated FOMC meeting since Chair Jerome Powell announced Average Inflation Targeting in August. For the first time the FOMC collectively projected that Core PCE would overshoot their 2% target, but also as a group did not expect to raise rates anytime between now and 2023. The minutes give us a window into how that debate evolved, which in turn should help us understand what it might take for the Fed's patience to run thin. These are the highlights. Fed (still) not worried about higher long-term interest rates During the post-meeting press conference, Powell waived off concerns about how much longer-term interest rates had increased. Between the Fed's January and March meetings the 10-year had risen from 1.02% to 1.65%, but Powell repeated a line that other Fed officials had said (and have said since) that if yields are rising because of economic optimism, the Fed doesn't mind. The minutes backed up what Powell said in his presser: Participants commented on the notable rise in longer-term Treasury yields... and generally viewed it as reflecting the improved economic outlook, some firming in inflation expectations, and expectations for increased Treasury debt issuance. One thing we should watch is whether the Fed's tune changes if the nature of yield increases changes. For most of 2021, higher Treasury yields have been predominantly due to higher inflation expectations in the out years. In a sense, this is the Fed gaining credibility about AIT. The Fed wants inflation to be higher in the out years, and the market is coming around to the idea that the Fed just might be successful. In particular this resulted in the yield curve steepening, i.e., 10-30 year bond yields rising by more than shorter-term bonds. Since the Fed's March 17th meeting, that trend has reversed. The 5-year Treasury has risen by 5bps while the 30-year has fallen by 10bps. Moreover TIPS breakevens have fallen off slightly, with the 5-year falling from 2.64% to 2.57% now. None of these moves are that large in the scheme of things, but the change in direction for both curve shape and inflation expectations are notable. I believe this indicates that the market has made an important pivot. Until now, good economic news meant more inflation and thus a steeper curve. However the market knows there's only so much inflation the Fed will tolerate, even under AIT. So now I expect that stronger economic data will actually cause the market to assume more rate hikes down the road. That will put more pressure on the 5-7 year part of the curve and not as much on the 10-30 year part of the curve. That may make the Fed uncomfortable, especially if rate hike expectations start to really grow for 2022. I doubt the Fed would do anything more than try to talk down expectations, but readers should note that there may very well be a different reaction function for the Fed depending on which parts of the curve are moving. Where might there be froth? There are definitely signs of ebullience all over markets, from SPACs, speculative stocks, cryptocurrencies, to more mundane things like housing prices. While I think the link between zero interest rates and this kind of speculation is weaker than many assume, it is undoubtedly the case that the Fed's actions have resulted in a surge of optimism. That optimism is driving all kinds of asset prices higher. How much is the Fed worried about this? In the past, Powell was strident in his nonchalance on the matter. He has said consistently that the only thing the Fed cares about is the real economy, i.e., jobs and inflation. By implication, he only cares about frothy prices to the extent that they impact jobs or inflation. Powell's take on financial market risks seems to the general consensus within the committee. A couple participants expressed concern about excessive risk taking and that's it. My take is that the Fed is concerned with price bubbles only when they could have contagion to the banking system. Things like Cathie Wood's stocks or bitcoin don't have any link to banks. The Fed is completely ignoring those areas of froth. Home prices could cause such a problem, as they obviously did in 2008, but I suspect the Powell Fed will try to use banking regulatory rules to address mortgage lending should housing continue to surge. For the moment it looks more like a problem of a surge of suburban demand meeting a pandemic-driven lack of supply. The Fed sees it that way as well. The minutes cited low inventory as the primary reason for rising home prices. We probably aren't close to a systemic risk in housing. Tapering first, rate hikes later One clear point that came out of the March FOMC meeting was the order of operations for policy tightening. First the Fed will have to see it [inflation] first. Then the Fed would telegraph well in advance that they were thinking about tapering QE purchases. Then the actual QE tapering. Only after all that would rate hikes occur. It was clear from these minutes that such a time isn't close. The general consensus was that it would be some time before substantial progress toward the Committee's goals would be met, and until such time, the QE program should continue as is. Right now the market is assuming the Fed will hike 4-5 times between now and 2023, with hikes starting sometime in 2022. Based on the sequence described above, 2022 seems too quick. In order to have rate hikes starting in 2022, the Fed would probably have to be tapering by the beginning of 2022, which in turn suggests the Fed would have to be telegraphing well in advance within the next couple months. Given that these minutes suggest it will be some time before their goals are met, this seems very unlikely. I don't think the market has thought the sequence through. We could see QE tapering begin in mid/late 2022, but right now that's when markets are thinking rate hikes are coming. I remain of the view that the market is about a year too early on the timing for rate hikes.

Highlights From the March FOMC Minutes

I expect that stronger economic data will actually cause the market to assume more rate hikes down the road.

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