Fed’s Powell faces ‘what, me worry?’ moment of spiking bond yields, war

U.S. Federal Reserve Chair Jerome Powell holds a press conference in Washington, U.S, Sept 20, 2023. REUTERS/Evelyn Hockstein/File photo

WASHINGTON  – Federal Reserve officials may not raise interest rates when they meet in two weeks but neither will they say their 19-month drive to hike borrowing costs is over, a difficult messaging challenge U.S. central bank chief Jerome Powell will take on this week.

It has been a whirlwind since the Fed decided to hold rates steady at its Sept. 19-20 meeting:

* Reports have shown the economy still growing too fast to cool inflation fully, while rocketing bond yields could push that activity to a hard stop;

* War has erupted in the Middle East;

* Half of the U.S. Congress is leaderless with a government shutdown deadline approaching;

* And underlying inflation appears to be cooling, but a jump in housing and services prices in September threatened, as one analyst said, to spoil the Fed’s “narrative” that price pressures would continue to wane.

With fodder to bolster either side of the policy debate, Powell must make sense of it all without triggering either unwarranted confidence that financial conditions are tight enough to lower inflation to the Fed’s 2 percent target, although that may be true, or unwarranted fear the central bank will need to crack down with higher interest rates, which could also be true.

Powell is scheduled to speak on Thursday to the Economic Club of New York, likely marking the final substantive comments from a Fed official ahead of the Oct. 31-Nov. 1 policy meeting. Analysts expect one main theme will be Powell’s views on the recent swift moves up in bond yields that could help the central bank achieve its inflation goal, but also show policy approaching an important juncture.

The Fed “has pivoted rather quickly from a singular inflation focus to weighing recession avoidance,” analysts at Monetary Policy Analytics, led by former Fed Governor Larry Meyer, wrote last week.

‘A lot has changed’

Balancing the two with the right policy setting now hinges in part on whether the rise in Treasury yields is due to investor expectations of further Fed rate increases or to changing views of the economy and the risks facing it.

In one case, the Fed might feel compelled to follow the market higher and meet those expectations; in the other, investors are essentially helping the Fed along and substituting for further Fed hikes, Meyer and his colleagues wrote.

Since the September meeting “a lot has changed,” Krishna Guha, vice chairman of Evercore ISI, wrote after several Fed officials last week signaled the rise in bond yields might take more rate hikes off the table. “The Fed is now paying attention.”

The next meeting may well open a new chapter in the policy discussion, with Powell’s remarks on Thursday possibly laying the groundwork.

If, as expected by financial markets, the central bank holds rates steady on Nov. 1, it will be the first time since the current tightening cycle began in March 2022 that it has gone consecutive meetings without a hike.

Describing that anticipated outcome while keeping open the possibility of future rate increases will be one challenge Powell faces.

Another will be discounting speculation about the prospect of rate cuts or changes to other aspects of Fed policy, such as the ongoing reduction of the central bank’s balance sheet.

It is a key moment for Powell to take stock, made even more critical by the outbreak of war between Israel and the militant Palestinian group Hamas as well as a political battle in Washington that saw Republicans oust their top leader in the U.S. House of Representatives.

Since the Fed lifted its benchmark overnight interest rate by a quarter of a percentage point to the 5.25 percent-5.5 percent range in July, long-dated bond yields have shot up by nearly a full percentage point, an outsized move that will push up rates on consumer and business loans.

While that might help slow inflation, it can also go too far. The yield on the 10-year Treasury note is just about six-tenths of a percentage point below the Fed’s policy rate; when the gap between the two shifts from negative to positive is when monetary policy gets perhaps its truest test. Those moments tend to be followed by recession. When they aren’t, it can signal the “soft landing” the Fed seeks.

‘Nascent upturn’

Powell needs also to address where he thinks inflation is headed. Recent data on balance don’t fully back the Fed’s view of a gently slowing economy and steadily easing inflation.

Fed Governor Christopher Waller last week referred to a “booming” economy, with third-quarter gross domestic product growth possibly hitting a 4-percent annual rate.

That is more than double the “potential” growth rate the Fed sees as consistent with its 2 percent inflation target, and which serves as a benchmark for how much it feels the economy needs to slow to regain price stability.

While Waller noted inflation also seemed to be in decline, he spoke before the release of consumer price data for September that complicated the discussion.

Underlying “core” inflation did slow, but other details were not so comforting, including a large increase in housing inflation that went against the Fed’s expectation for easing shelter cost pressures and a larger rise in parts of the service sector where policymakers worry inflation is the most entrenched.

Powell will have to say if that has shaken his faith in continued “disinflation.” The economy’s ongoing strength has some analysts saying that it should.

The data for September “do not support the Fed’s narrative that disinflation will march on … even if the economy keeps growing and unemployment stays low,” said Steven Blitz, chief U.S. economist at TS Lombard, arguing the economy experienced a “nascent upturn” in the middle of the year that is “beginning to reverse disinflation as well.”

“Assuming the economy keeps growing … the Fed will get back to hiking,” Blitz said. “Whether the economy holds up … is a different story.”