The markets are likely to remain focused on Fed policy this week, as Fed Chair Powell testifies to Congress and other Fed officials make speeches. They are not likely to diverge from the views expressed in last week's FOMC Statement. There also will be Treasury auctions this week, with the most important perhaps being the 7-year -- which showed weak demand at last month's auction. The degree of demand this time would bear on whether yields have moved up enough.
The Treasury market so far has clearly not been convinced of the benign Fed outlook of modestly above-trend growth and slight uptick in inflation in the next couple of years, despite a strong recovery from re-opening in 2021 and continuation of very low short-term rates. It apparently is concerned that inflation will rise faster. In addition, the markets were hit with Friday's announcement of the Fed's unexpected decision to allow the expiration of an easing of banks' reserve requirements at month end.
Market commentators focused on the possibility that a renewal of the requirement for banks to hold reserves against deposits and Treasury holdings will force them to sell Treasuries. But, this implication may not be right from a macro perspective. The Fed may have to buy Treasuries in order to supply the increased demand by banks for reserves (otherwise short-term rates would rise -- contrary to the Fed's desire). The more important implication may be that the Fed in effect tightened by increasing the bank reserve requirement. As market commentators point out, the increased requirement could lead to banks to cut lending (eg, by tightening lending standards). From this perspective, the Fed did half of an operation twist but one that should be a positive for the longer-end of the curve -- tightening but not by raising short-term rates. It also should hurt cyclical as well as bank stocks.
There is irony in curtailing bank lending, particularly if, as reported, Congressional Democrats argued strongly for the Fed to renew the reserve requirement. By holding back this channel of monetary policy, other channels -- most importantly stocks and longer-term Treasuries -- have to work harder to achieve the Fed's goal of full employment. One result is the need for low short-term rates to continue. Another is an exacerbation of unequal wealth distribution. This happened in 2009 when Democrats pushed for tighter restrictions on banks.
The broader question is whether the Fed is right in its forecast of only a modest increase in inflation over the next couple of years. Fed officials argue that this is the most likely outcome as long as longer-run inflation expectations remain contained. So, reports like the University of Michigan 5-Year Inflation Expectations should become more market significant. (This measure is at 2.7%, the high end of its recent 2.5-2.7% range.) Current inflation prints are less important since they can be impacted by temporary factors.
The most important determinant of inflation is the pace of labor costs. Unfortunately, almost all measures of aggregate labor costs have been distorted by large compositional shifts between high- and low-paid workers as a result of the uneven impact of the virus on jobs. Perhaps the least affected is the Employment Cost Index, since it holds job distribution constant. The ECI shows no significant acceleration, if any, so far.
In regard to wage inflation, the most important piece of information in the next couple of weeks could be the March Unemployment Rate. The markets could view a steady to higher level as taking some upward pressure off wage inflation. Even Fed Chair Powell admits to an inverse relationship between the Unemployment Rate and Wage Inflation, although he says the relationship between wage and price inflation is not one-for-one.
The currently low inflation rate should be seen in the February Core PCE Deflator in this week's report. Consensus looks for a modest +0.1% m/m with a steady 1.5% y/y. Most of this week's other data -- Existing and New Home Sales, Personal Income and Consumption -- are expected to decline, reflecting temporary factors like the bad weather. The declines should be dismissed. The most interesting of the real-side data will be Initial Claims to see if they unwind the prior week's difficult-to-explain jump.
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