Fed Minutes to Come Today. Look for Insights on Rates, Mortgage Bonds, and More.

Here are a few things to watch for in this week’s minutes and in central bankers’ commentary leading up to the next policy meeting and beyond. 

Financial Conditions

When Fed officials and economists talk about “financial conditions,” they are referring to things like stock-market levels and corporate-bond spreads. Those are some of the transmission mechanisms of monetary policy, affecting households and businesses through the wealth effect and cost of credit. 

Since the Fed last met, financial conditions have tightened sharply. Investors are looking for clues over how much more the central bank would like stocks to fall and credit spreads to widen. Economists at

Deutsche Bank

note that in his postmeeting press conference last month, Fed Chairman Jerome Powell mentioned “financial conditions” 16 times, an indication that the topic was a focus of the meeting. 

“Powell and his colleagues have demonstrated an increasing focus on tighter financial conditions as a replacement for providing more forceful guidance on whether the fed funds rate will need to reach a restrictive level over time,” the Deutsche Bank economists say, meaning financial conditions are key to predicting how high rates will go—and when they might start to reverse. Economists there and elsewhere say the Fed probably wants financial conditions to continue tightening, at least for now, given how high inflation is running. 

For context, economists at Goldman Sachs say their GS U.S. Financial Conditions Index tightened by about 0.6%, to 99.29, over the last week. About a month ago, the metric stood at 98.64; at the beginning of the year, it was about 97.

Inflation

While financial conditions are tightening, inflation is still at a four-decade high. The consumer price index rose 8.3% in April from a year earlier, largely bucking expectations for inflation to have peaked. While there are signs of cooling pricing pressures across goods, shelter inflation is stubborn and rising, the costs of essentials are high, and prices of services are increasing. 

“With equity markets down and credit spreads wider, the U.S. central bank is certainly getting what it has wished for,” says Katie Nixon, chief investment officer for Northern Trust Wealth Management. “When we have seen these conditions in the past, the speed of these moves has prompted the Fed to retreat from well-laid plans to tighten policy,” she says. But the Fed is unlikely to reverse course now, given how far behind the inflation curve the Fed has fallen, Nixon says. “The Fed has identified inflation as public enemy number one, and risks a credibility crisis if policy is changed at this point,” alluding to the idea that dramatic market declines won’t as easily trigger the so-called Fed put this time.

In its May policy statement, the Fed said inflation risks are to the upside, given food-and-energy commodity shortages stemming from Russia’s invasion of Ukraine and China’s Covid-related lockdowns that have exacerbated supply-chain disruptions.  

In an appearance on May 17, Powell said he wants “clear and convincing evidence” of falling inflation before slowing down the pace of rate increases. That is legalese for the second-highest proof standard and requires that evidence be highly probable, says Joseph Wang, previously a senior trader on the Fed’s open markets desk and a lawyer. Traders will be looking for any change in language and tone around the projected path of inflation and risks to the Fed’s forecasts, which will next be updated in June.

Slowing Growth and a Soft, or Softish, Landing

Powell has argued that the Fed could engineer a soft landing—meaning growth would continue as the central bank tightens monetary policy to combat inflation, and Wall Street mostly agrees. That claim, however, has led some market participants to doubt the Fed would be tough enough on inflation, setting up stagflationary dynamics of slowing growth and high prices. 

Recently, Powell’s tone has shifted. First he used the word “softish,” instead of “soft,” and then last week said taming inflation could lead to a “bumpy” landing. “There could be some pain,” he warned. 

The Fed’s May statement acknowledged the surprise decline in first-quarter gross domestic product from a quarter earlier, but it said household spending and business fixed investment remained strong. Recent earnings reports from America’s biggest retailers have challenged the dominant narrative that because consumers—about 70% of GDP—amassed trillions in savings during the pandemic, they will prevent the broader economy from falling into a recession. Still, the labor market is very tight. Economists expect the unemployment rate to dip to 3.5% when the May data are reported on June 3. That would match the half-century low notched before the pandemic and it suggests wage pressure won’t abate soon as employers struggle to find workers, though there are signs of rising layoffs.

Meanwhile, fast-rising mortgage rates are slowing housing demand, but prices continue to rise because there isn’t enough inventory. Rents lag behind home prices by about a year, and shelter comprises about a third of the CPI, meaning upward pressure from that category is going to be hard to battle. 

How the Fed views these cross-currents will be key to predicting how aggressive policy tightening remains in the coming months, especially as the central bank begins to shrink its balance sheet. 

Potential MBS Sales

The Fed has said it would start shrinking its $9 trillion balance sheet beginning June 1, when it will no longer reinvest proceeds of up to $3 billion in maturing Treasury securities and up to $17.5 billion in mortgage-backed securities a month. Those caps are to rise to $60 billion and $35 billion, respectively, in September. 

But some officials have suggested they will need to become more aggressive in the attempt to partially unwind quantitative easing, or the pandemic bond-purchases over the past two years, specifically as it relates to the housing market. Shrinking its $3 trillion in MBS holdings will be particularly difficult, given that prepayments—driven by refinancing activity—all but stop as rates rise and so natural rolloff is slow.

Minutes from the Fed’s March meeting showed officials discussed the potential need to outright sell MBS. Economists at Citi note that recent Fed speak suggests the topic may not have been “robustly discussed” at the last meeting, so any indication to the contrary would represent a hawkish surprise.

Write to Lisa Beilfuss at [email protected]