Fed’s new challenge: A strengthening economy

WASHINGTON » For the past year, Federal Reserve Chair Jerome Powell has expressed a wish for more rescue spending from Congress, better control of the viral pandemic and clear evidence of an improving economy. He’s finally getting all three. Yet all of that hardly makes Powell’s job easier.

At the Fed’s policy meeting this week and at a news conference to follow, the chair will take up a new challenge: Convincing financial markets that even as the economic picture brightens, the Fed will be able to continue providing support without contributing to high inflation. Powell’s message will likely be that the economy still needs substantial backing from the Fed in the form of short-term interest rates near zero and bond purchases that are intended to lower long-term borrowing rates.

Complicating the Fed’s task is that investors envision a swift and robust recovery later this year that could accelerate inflation and send long-term rates surging. Behind that fear is the belief that as vaccines are more widely administered and money from President Joe Biden’s $1.9 trillion rescue package flows through the economy, growth will accelerate so fast that the Fed will feel compelled to quickly raise rates to quell inflation pressures. If that were to happen, the economy could suffer another setback.

The economy’s outlook has improved significantly since the Fed’s policymaking committee last met in late January. Job gains accelerated in February, sales at retail stores jumped after $600 relief checks were distributed at the start of the year and Biden signed his economic relief package into law last week.

The stronger outlook has sent the yield on the 10-year Treasury note climbing as investors have dumped bonds, which are typically safe-haven investments during downturns. The yield on the 10-year reached 1.62% in afternoon trading Friday; it had been below 1% at the end of last year. The rise in the 10-year yield in recent weeks “caught my attention,” Powell acknowledged earlier this month.

In anticipation of faster growth and inflation, investors have priced in at least three Fed rate hikes by 2023 — a much earlier lift-off than the Fed itself has forecast. In December, the central bank leaders projected that they wouldn’t begin raising rates until at least 2024.

Seeking to reassure investors, Fed officials have said they regard the rise in the 10-year yield as a positive sign, evidence that the financial markets expect the economy to steadily strengthen.

“Markets are responding to the ongoing, and accelerating, recovery,” said Lewis Alexander, an economist at the investment bank Nomura. “In many respects, the Fed is dealing with the problems of success.”

But if longer-term rates rise too high, the economy could suffer as borrowing becomes more expensive for consumers and businesses. The average rate on a 30-year fixed mortgage, for example, has topped 3% after having set a record low of 2.65% as recently as early January. When the Fed’s meeting ends Wednesday, much attention will focus on the release of its updated economic and interest rate projections. The central bank issued its most recent projections in mid-December, before it was clear whether Congress would approve a $900 billion rescue package or how much more federal aid Biden would manage to enact. Since then, roughly $2.8 trillion in economic relief has been approved.

Average daily COVID infections have also dropped precipitously, and vaccinations have accelerated. As a consequence, Fed officials will likely boost their projections for economic growth for this year and for 2022, lower their estimates for unemployment and raise their expectations for inflation.

Fed officials may project economic growth this year of as much as 5%, economists say. After a 3.5% contraction in 2020, many private-sector analysts are forecasting growth of roughly 7% this year. That would be the fastest calendaryear U.S. expansion since 1984.

Acknowledging those improvements could make it harder for the Fed to convince financial markets that it will remain “patient” about raising rates, as Powell has stressed in recent weeks.