Fed sees rising bond yields and inflation expectations as a possible victory

(Reuters) – A recent spike in US bond yields and market inflation expectations has raised Federal Reserve officials’ hopes that the central bank’s new monetary policy approach is firming up and could be further strengthened if a Congress led by Democrats distribute more spending.

“I am excited to see the increase in market indicators for inflation expectations. … this is what we are trying to support, ”Richmond Federal President Thomas Barkin said in an interview with Reuters on Thursday.

Barkin said he considered the recent increase in interest rate on Treasury bills also part of a “reflective trade”, a sign that investors were considering future price increases in their decisions by demanding higher interest rates instead to represent a worrying tightening of finance conditions.

“The ingredients for higher inflation already exist,” St. Louis Fed President James Bullard said in separate comments to reporters. “You have a very powerful fiscal policy in place and perhaps more to come,” with Democrats about to take control of the White House, as well as the US Senate and House of Representatives.

“You have a Fed that … wants to temporarily have inflation above the target. You have the economy ready for a boom at the end of the pandemic, ”once the impact of the new coronavirus vaccines is felt, said Bullard.

The 10-year reference Treasury yield rose above 1.07% on Thursday, reaching its highest level since March. The expectation of future 5-year inflation reached a maximum of 2.05% in two years.

‘INCREDIBLY DISAPPOINTING’

After almost two years of study, the Fed in August changed its approach to monetary policy to allow for higher inflation, hoping to meet its 2% target on an average basis, allowing prices to rise for some time to compensate for years in that inflation had been weak.

This would also, in theory, allow a lower unemployment rate, as the central bank would try to sustain the type of “hot” economy that leads to higher prices.

The huge uncertainty about the economy and the course of the pandemic at the end of last summer gave way to what Barkin said was more “clarity” about where things are – with two coronavirus vaccines being distributed, tax buffers in place to help many families American consumers, and consumers “not far” from the point where “they will engage in the economy with much more confidence”.

The pace of vaccine distribution will play a big role when that happens, with some lawmakers expressing dismay at the effort so far.

Philadelphia Fed President Patrick Harker called the first vaccination numbers in the United States, with less than 5 million vaccines inoculated so far, “incredibly disappointing.”

But the events of the past few weeks seem to have changed the market’s bets on the future, with trading in inflation-linked securities suggesting that investors expect higher inflation and accept that the Fed will not get in the way.

“We are facing a long period in which the federal funds rate will remain essentially at zero,” said Harker, referring to the central bank’s main overnight interest rate. He added that he saw no signs that “inflation is going to get out of control”.

In fact, Chicago Fed President Charles Evans has expressed more skepticism about inflation to come, even with the additional government stimulus that may be on its way to help combat the economic consequences of the pandemic and the recession it has unleashed.

The rise in inflation due to rising fiscal spending, he told a group of bankers on Thursday, is not “as strong as I would like”. He said he believed inflation would not reach 2% until 2023 and that it would be unreasonable for the Fed to wait until mid-2024 to raise short-term rates from their current levels close to zero.

San Francisco Fed President Mary Daly, at an event organized on Thursday by the Manhattan Institute’s Open Shadow Market Committee, said she believed that a stronger labor market will eventually generate higher inflation, although it is likely that upward momentum on prices in a tight labor market weaker than in the past, making a sudden wave unlikely.

This means, she suggested, that the Fed may allow the labor market to strengthen even more than in the past.

At the same time, Daly said he was reassured by a recovery in inflation expectations, which showed market participants, households and companies are beginning to believe that the Fed will meet its goal of overcoming 2% inflation.