Reading the FOMC: ‘The Powerful Hawk in the Shadows’ Is Yellen

“If Janet Yellen were the chair of the Federal Reserve Board and not the U.S. treasury secretary, would she be a tapering (quantitative easing reduction) progressive?”

That was the talk on Wall Street last week ahead of this week’s U.S. Federal Open Market Committee meeting on June 15-16.

In her current position of treasury secretary, Yellen said to the media after the London meeting of the Group of Seven major industrial nations financial ministers and central bankers: “If we ended up with a slightly higher interest rate environment it would actually be a plus for society’s point of view. We’ve been fighting inflation that is too low now for a decade. We want them to go back to a normal interest rate environment, and if this helps a little bit to alleviate things then that’s not a bad thing — that’s a good thing.”

In no way did she pressure the Fed by alluding to an “interest rate hike.”

An unprecedented increase in the issuance of U.S. Treasuries to finance President Joe Biden's large economic support plan is unavoidable, and without the also unprecedented low levels of funding costs, the cumulative budget deficit will only grow. Therefore, from the standpoint of the treasury secretary, it is preferable that U.S. Treasury yields be lower. However, it is unavoidable that the issuance of trillions of dollars of government bonds will be a primary factor in the rise in long-term interest rates. Even from the position of treasury secretary, she has to admit that there will be a moderate rise in long-term interest rates.

However, if Yellen were the Fed chair, as a labor economist, the U.S. labor market recovery would still be K-shaped, and she would still be cautious about tapering. Previously, as Fed chair, Yellen was a leading representative of the zero interest rate policy “doves.” Thus it has become a topic of discussion that with a change in position comes a change in public remarks.

The treasury secretary is aware of long-term interest rates; short-term interest rates are a full-time matter for the Fed chair, but currently the Fed can restrain long-term interest rate rises by large-scale purchases of U.S. government securities. Particularly since the Fed also includes price-linked bonds in its purchases, it also plays a role in directly suppressing the expected inflation rate (the expected inflation rate is calculated from the yield gap between ordinary government bonds and price-changing bonds).

These are the circumstances in which the FOMC will be held on June 15-16.

The market is expecting the current Fed chair, Jerome Powell, to seal the tapering discussion without changing the theory that “inflation is temporary.” “Seal” is used because there are supporters of tapering (hawks) among the FOMC participants. For example, Dallas Federal Reserve Bank President Robert Kaplan told the Nikkei that "It's not a calendar-based judgment; it's outcome-based," and acknowledged that early policy shifts could be possible. In an interview with the U.S. TV channel CNBC, discussing the latest version (announced in March) of the dot point graph showing the distribution of FOMC members’ future interest rate predictions, he admitted to being one of the four “hawks” forecasting rate hikes in 2022.

In addition, San Francisco Federal Reserve Bank President Mary Daly has alluded to the possibility of “talking about talking about” tapering. It attracted attention in the market as a statement that goes one step further from Powell’s remarks: “We are not even thinking about thinking about raising rates.”

It was reported last week that Philadelphia Federal Reserve Bank President Patrick Harker said, “But it may be time to at least think about thinking about tapering our $120 billion in monthly Treasury bond and mortgage-backed securities purchases.”

When this happens, market interest will turn to the dot chart in the Fed's June economic report, which will be released at the same time as this week's FOMC statement. [The interest will be in] whether the number of [Fed members predicting] 2022 rate hikes, which was four in the March edition, is increasing or not.

In the previous instance, it was clarified afterwards in the Fed’s minutes that “a number of” participants were positive about discussions on reducing quantitative easing, which was viewed as material in the market.

This time, however, the yield on 10-year bonds has dropped to the 1.4% range in the most recent U.S. bond market, despite steep rises in price indices. The reality of this is seen in the short squeeze (constriction of short selling) observed in the New York market. Short selling of U.S. Treasuries, which are expected to fall in value as interest rates rise in anticipation of tapering, has piled up to a level that is being called the "most crowded trade," and just before the FOMC, there was concern about a shortage of U.S. Treasuries, which serve as collateral for short selling. Therefore, many involved in the New York markets are leaning toward the trend of rising dollar interest rates resuming over the medium term.

The current problem is whether or not the inflation is “temporary.” As far as the FOMC is concerned, there is no circumstantial evidence to overturn Powell’s strongly held view that it is “temporary.” If Powell gives the impression that his conviction of its being "temporary" is wavering even for an instant, it will rekindle the strong dollar interest rates, the strong dollar, and the NASDAQ market-led fall in stocks. The author sees the FOMC as a "zero answer" to market questions. The U.S. economy is recovering quickly, but interest rates aren’t spiking. As a result, it is possible that the market will remain at the right temperature (the so-called Goldilocks [point]) until the Jackson Hole meeting in August, without being too hot due to overheating or too cold due to stagnation.