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Derby's Take : After Bond-Market Tumult, Some See Need for Stronger Fed Response

03/02/2021 | 05:44am EDT

By Michael S. Derby

Some economists and market participants believe the Federal Reserve needs to speak more directly to a bond market that has seen yields surge amid uncertainty about the monetary policy outlook.

Treasury yields shot higher last week, and higher long-term interest rates in theory could create unwanted headwinds to growth as the economy recovers from the coronavirus pandemic.

Fed officials including New York Fed leader John Williams have said that rising yields are consistent with what appears to be a strong path of recovery and that they see no need for the central bank to respond.

Rising yields are "driven by a more positive outlook for the economy...and maybe, you know, a more stabilized view of inflation versus where we were before," Richmond Fed leader Thomas Barkin said last week. Separately, Atlanta Fed leader Raphael Bostic last week said he isn't worried and that "I'm not expecting that we'll need to respond in terms of our policy." Messrs. Williams, Barkin and Bostic hold votes on the rate-setting Federal Open Market Committee.

Lots of market participants don't think that rhetoric will continue to fly, and some believe this is the week for officials to change their story. A number of Fed officials will make public appearances this week, including Fed governor Lael Brainard and San Francisco Fed leader Mary Daly on Tuesday, Chicago Fed leader Charles Evans on Wednesday, and Fed Chairman Jerome Powell on Thursday. All these officials have FOMC votes as well.

"We think Fed officials will change tactics and intervene verbally," economists at Oxford Economics said in a note. "Most likely they will emphatically affirm their patient and dovish stance, which accords with their new policy framework."

"A repeat of last week's disorderly jump in yields would threaten the economic recovery," the Oxford economists wrote, adding: "Policy makers will need to walk a fine line between calming impatient bond markets while not sounding too sanguine about higher inflation risks."

That said, the challenge before the Fed is large. Understanding what's going on in the market right now, and how it relates to monetary policy, isn't settled, and some think it may not even be driven by economic considerations.

On top of that, the Fed is being battle-tested on its new policy regime. Last year, it adopted a new policy-making system that aims for inflation to overshoot the official 2% target to make up for times it has fallen short.

The problem for market participants is that the central bank has deliberately left vague how much of an overshoot it would tolerate before raising short-term rates. The Fed also has left vague what it would take for it to pare back on its other leg of support: $120 billion a month in Treasury and mortgage bond buying.

Officials expect inflation to pick up for a time before easing as the recovery speeds up this year. As market participants brace for higher inflation, they are unsure how price dynamics will react in an economy recovering from an unprecedented shock and under a monetary policy regime some see as vague.

Robin Brooks, chief economist with the Institute of International Finance, said the problem the Fed faces is that its new rate guidance system targets short-term rates and doesn't address longer-term yields, which is where the problem has been.

Mr. Brooks said the work the Fed will need to do to keep long-term yields down and moving in an orderly fashion is rhetorical. He said the Fed will need to talk down coming growth data that could be strong. Officials can also directly state that yields have risen too much and note they are monitoring the situation, he said.

"I think between clarifying Q2 GDP and doing some verbal intervention you can already achieve a lot," Mr. Brooks said.

Oxford Economics believes the next step for the Fed, if talking doesn't work, would be to change the pattern of its bond buying toward longer-dated bonds, in a bid to push down those yields.

But Wrightson ICAP economists are skeptical of such a strategy. In a research note, the firm said the Fed has long anticipated unruly bond-market action along the lines of the so-called taper tantrum episode of 2013.

"Moving aggressively to flatten the curve now might just set the stage for another tantrum down the road," Wrightson ICAP said. "And that tantrum might be more extreme if the market has become more dependent on long-duration Fed purchases." The firm expects the Fed will try to navigate the situation by again explaining its new policy-making system, all as part of an effort to play down any sense that the timing of a Fed rate rise has moved forward.

Write to Michael S. Derby at michael.derby@wsj.com

(END) Dow Jones Newswires

03-02-21 0544ET

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