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Fed's patience on rates could be tested as markets see post-COVID-19 boom

A year after COVID-19 roiled the global economy, Federal Reserve officials are facing the potential for a boom fueled by widespread vaccinations and a $1.9 trillion stimulus.

The rebound could be so strong that Fed officials today may drop their first hint of raising short-term interest rates from effectively 0% as early as 2023, according to some analysts. Others, however, believe the Fed's quarterly forecasts will indicate that ultra-low interest rates may be necessary for the foreseeable future to support the economic recovery.

Fed Chairman Jerome Powell is likely to highlight the brighter economic outlook after the central bank's March 16-17 meeting, but analysts also expect he will temper that optimism and remind the public the U.S. economy is a long way away from its pre-COVID-19 state.

"I think he will be relatively upbeat, [but] he will rely on the uncertainty of the situation to provide dovish messages," said Bruce Monrad, portfolio manager at Northeast Investors Trust.

That dose of caution will be particularly necessary if the Federal Open Market Committee's quarterly "dot plot" forecasts indicate the 18-member panel is leaning toward raising interest rates in 2023, a hawkish shift that Powell may look to downplay at his 2:30 p.m. ET news conference. If enough Fed officials pencil in a rate hike in their individual 2023 forecasts, analysts say that would validate market expectations that the central bank will tighten policy sooner than it has predicted.

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Last summer, Powell said the central bank was "not even thinking about thinking about raising interest rates," a mindset that continued as the year progressed. Fed officials' most recent forecasts, from December 2020, showed a strong consensus among policymakers that no rate hikes would be needed in 2023, with only five of them penciling in some tightening.

But much has changed since the December 2020 forecasts. President Joe Biden, with the help of a new Democratic majority on Capitol Hill, has signed a $1.9 trillion stimulus package into law that economists say will provide a meaningful boost to growth in the coming months. COVID-19 vaccines are also being distributed rapidly in the U.S., with more than 2 million vaccines administered in the country each day, according to an Oxford University tracker.

The potential for a large post-COVID-19 spending boom has prompted private sector economists to anticipate higher growth in their projections. Fed officials are expected to follow suit in their fresh round of forecasts, raising their view on GDP growth in 2021 from an already strong projection of 4.2%.

"Given the magnitude of the likely forecast revisions, it would be hard to justify no change in the policy outlook," wrote Aneta Markowska, chief financial economist at Jefferies LLC, in a note to clients. Markowska sees a good chance of the median view at the Fed shifting toward one hike in 2023 but noted that would be less aggressive than current market pricing of three rate increases.

In his most recent remarks, Powell said he expects the Fed "will be patient" in pulling back its low-rate policies, seeing reason for optimism but stressing that there is "a lot of ground to cover" before the U.S. economy achieves a full recovery.

"The sooner that happens, the better, but I would say realistically that's going to take some time," Powell said at a Wall Street Journal event on March 4.

He also has downplayed the potential for inflation to accelerate unhealthily in the coming months, saying he expects inflation to see upward pressure after the COVID-19 pandemic is under control but that the increases should be neither "large" nor "sustained."

Bond investors appear to hold a similar view. The five-year breakeven inflation rate, a rough measure of bond investors' view of inflation over the next five years, has quickly risen to around 2.5%. But the bond market expects some of those inflation increases to fade away, judging by the lower 10-year breakeven rate of roughly 2.25%.

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Actual inflation data remains significantly below the Fed's 2% target. The core personal consumption expenditures price index, which excludes food and energy prices, rose by 1.5% year over year in January. Under their new monetary policy framework, the Fed is looking for inflation to rise modestly above the 2% goal for some time to roughly compensate for the time inflation was below-target.

Fed officials have also said that any future rate hike considerations will be based on actual inflation data — rather than getting ahead of the data and reacting to forecasts of stronger inflation. If the forecasts do show a majority of Fed officials are penciling in a 2023 rate hike, that will undermine the Fed's new framework and suggest "the new Fed will be just like the old Fed," according to Tim Duy, a University of Oregon professor who is chief U.S. economist at SGH Macro Advisors.

The focus on the Fed's 2023 plans has shifted some attention from the future of the central bank's bond purchases, which are currently running at a clip of $120 billion a month.

Fed officials have promised to keep up that pace until they see "substantial further progress" on their goals, and Powell has said it will take "some time" to meet that threshold.

Powell is likely to restate that message at his news conference and signal no shift in the Fed's bond-buying operations, according to Seth Carpenter, a former Fed staffer who is now chief U.S. economist at UBS. But when Powell eventually removes that "some time" qualifier, that will be a strong signal to markets that the Fed will start to reduce its monthly bond purchases soon, Carpenter wrote.

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