“It’s a really tricky needle to thread.” That’s how former Federal Reserve economist Claudia Sahm describes the task at hand for Chair Jerome Powell at the Fed meeting this week. Bitcoin (BTC) traders aren’t sure he can pull it off.
Considering the massive economic dislocation over the past year from the coronavirus, the current level of interest rates and monetary stimulus appears to be just right, and data on everything from inflation to employment is about as good as one might hope.
Powell’s challenge will be to convince investors the Fed can maintain the pristine conditions even as the economy reactivates, potentially sparking a surge in consumer demand that could lead to faster inflation. Investors will be watching for any advance indications as to how quickly output would have to ramp up before the Fed moves to taper its $120 billion-a-month of bond purchases – an extreme form of loose monetary policy – and eventually raises interest rates, currently set at near 0%.
It’s a key question for traders in the market for bitcoin, seen by many big institutional investors as a hedge against the runaway inflation that might transpire if the Fed were to lose control. At issue is the credibility and resolve of the Federal Open Market Committee, or FOMC, which is the panel at the U.S. central bank that sets monetary policy.
“The Fed is going to have to work really hard to convince people that they’re honest,” says Sahm, now a senior fellow at the Jain Family Institute. “Like if things get out of hand, they will adjust, they will raise rates, but they don’t want them to think they’re going to raise rates.”
According to economists at Bank of America, the second-biggest U.S. bank, investors in traditional markets will be focused on whether Powell shifts his language around when “substantial further progress” will have been made in the economy.
Economists at Bank of the West, a unit of the giant French bank BNP Paribas, project that Fed officials will start talking about tapering their bond purchases later this year, with the actual tapering to begin in early 2022. Under their scenario, the first interest-rate hike would happen in the third quarter of 2023.
The two-day, closed-door meeting starts Tuesday and culminates Wednesday with the FOMC decision at 2 p.m. ET. The FOMC press conference with Powell is right afterward at 2:30 p.m.
The FOMC decision will be closely scrutinized by traders in the bitcoin market, especially because this year’s 90% price rally, fueled by speculation that faster inflation might be on the way, has stalled out in recent weeks. As of early Tuesday, bitcoin was changing hands around $55,000. It’s bitcoin, of course, where price volatility is the norm, so anything can happen, but the largest cryptocurrency is well off its all-time high price reached earlier this month around $65,000.
The Fed meeting follows a string of several weeks of positive economic data.
The U.S. added 916,000 jobs in March, far above the expected 675,000, with pandemic-wrecked portions of the economy like leisure and hospitality leading the way.
U.S. headline inflation in March came in at 2.6% over the prior 12 months, slightly faster than the expected 2.5%, based on the Labor Department’s consumer price index (CPI). Even that result might not be anathema to the Fed, since Powell has explicitly expressed his wish for inflation to average over 2%, at least for a while.
Gross domestic product (GDP), the broadest gauge of economic activity, appears to be on a path toward robust growth. Oxford Economics has revised up its estimate for U.S. GDP this year to 8% from 7.2%, said Kathy Bostjancic, chief U.S. financial economist for the forecasting firm.
Such momentum means that markets may see a more relaxed and confident Powell on Wednesday, said Steven Kelly, a research associate at the Yale Program on Financial Stability, an initiative focused on understanding financial crises.
“If you would have offered everyone on the FOMC the last six weeks of data, they would have accepted the deal,” Kelly said. “If we were in 2019 and CPI was bumping up a little higher in a way that hadn’t been communicated, there would be volatility in the bond market. But they’ve been very clear that inflation will bump above 2%.”
With the yield on 10-year U.S. Treasury notes around 1.55%, down from as high as 1.7% in March, there’s little pressure on the Fed to consider experimental monetary policies like “Operation Twist” and “yield curve control” that might loosen financial conditions further.
Inflation-adjusted yields on 10-year Treasurys – the nominal yield, minus the inflation rate – are at negative levels, said Bostjancic. They’re currently around -0.77%, down from 0.15% before the pandemic. On that basis, the 10-year yield could climb roughly 0.9 percentage point before conditions returned to pre-pandemic levels. In other words Powell’s got plenty of headroom on that front.
Even though Oxford projects 1.9% for the nominal 10-year Treasury yield by the end of the year, the numbers add up to “near the easiest financial conditions we’ve ever had,” Bostjancic added.
The FOMC will likely stay the course on keeping the target rate for federal funds in a range of 0% to 0.25%, while maintaining the monthly asset purchases at $80 billion of U.S. Treasury bonds and $40 billion of agency mortgage-backed securities.
It might be a sign the Fed sees no urgency in beginning to normalize conditions, a step taken recently by the Bank of Canada.
The path to full employment
With 8.5 million Americans unemployed, there’s a long way before full employment is reached. Powell has talked about this, and it’s likely to be on the agenda again at this week’s FOMC meeting.
Lower unemployment could force businesses to compete for the shrinking pool of available labor, leading to higher wages. But higher inflation could also increase the cost of living, hurting the lowest income earners in society.
One trade-off is that inflation makes it easier for borrowers to repay debt, Sahm said.
“It helps borrowers on the reverse side,” Sahm said. “If there’s higher inflation and wages tend to grow faster than prices, that means it takes less of your money down the road to pay back the bank. … Most economists, who are rich people, do not talk about the distributional effects of inflation.”
What makes bitcoin traders skeptical is the so-called Goldilocks scenario: that everything stays exactly as it is for the Fed meeting this week, rising gradually and in sync. Corporations see increased profits as consumer demand rises, thanks to the Federal Reserve’s accommodative monetary policy and fiscal stimulus from the U.S. government. Investors benefit from an uplift of asset prices. Inflation ticks up a bit, but not too much. Eventually the Fed has enough legroom to remove the monetary stimulus.
“The Fed will eventually slow down the asset purchases and probably end the asset purchases,” Sahm said. “The whole point of this is to get the U.S. economy to a better place. If the economy is in a better place, we’re in a good place to invest and asset prices go up.”
Even after this week’s Fed meeting has passed, getting there will be the tricky part.