The markets are on edge before the Federal Reserve’s policy update in the face of surging inflation

The Federal Reserve is not expected to take any policy actions after its two-day meeting this week, but it is likely to signal that it is thinking about them.

Stock futures were flat on Wednesday morning as investors awaited the 2 p.m. ET Fed statement and Chairman Jerome Powell’s news conference 30 minutes later.

Some economists expect the Fed to mention a coming tapering of its bond-buying program and give preliminary guidance on the discussion but not fully commit to tapering yet. The Fed will also release new economic forecasts, which it does quarterly.

There’s a chance it could pencil in an initial rate hike in 2023. In its previous forecast, there was no consensus for a rate hike among Fed officials though 2023.

 “I think the commentary and the press conference will be interesting. There’s clearly a division on the board and among the Fed presidents about how strong the economy is, and whether it’s time to start evolving the policy,” said Rick Rieder, chief investment officer global fixed income at BlackRock. “How the chairman describes that is going to be very interesting. It’s hard to say it’s [going to be] hawkish because … I think it’s going from uber dovish to overly dovish.”

At their last meeting, some Fed officials noted if the economy continued to make progress, it could be appropriate to begin discussing a plan for adjusting the pace of bond purchases, according to the meeting minutes.

That discussion could begin this week, but only on a preliminary level, some economists say. The real details of the tapering of its $120 billion monthly purchases are expected to come later this year. Many economists expect the official discussion to be in late August, when the Fed meets in Jackson Hole, Wyoming, for its annual symposium. The Fed could then begin unwinding its bond buying at the end of this year or beginning of next, they say.

“The message this week will likely be a heavy dose of “still a long way to go” sprinkled with concerns about upside risks to inflation. We do not expect the debate about tapering to be robust, but simply beginning the discussion and expressing concerns about the strong inflation impulse should carry hawkish overtones,” Barclays economists said in a note.

Tapering the bond program is important because the beginning of the end of its so-called quantitative easing signals the Fed would be on the path to eventually tighten policy — or raise interest rates. The Fed began purchasing Treasurys and mortgage securities last year as a way to provide liquidity when the Covid pandemic shut the economy down.

Once the Fed starts reducing the purchases, it could take months to be completed. When it reaches zero, the door would then be open for the Fed to raise interest rates. The Fed’s easy policies have been credited with fueling the stock market’s rally to repeated new highs and creating a robust environment for the housing market.

Powell could choose to bring up the tapering during his post-meeting press briefing, and he surely will be asked about it.

“We’re not expecting any major policy changes from the Fed. Most of it will be characterizations around tapering and what the Fed says about that, along with adjustments in the Fed’s forecast,” said Mark Cabana, head U.S. short rate strategy at Bank America. “On taper, we think they will start talking about talking about it. We anticipate Powell will reiterate that it is still some time away.”

But Goldman Sachs economists say it is too soon for the Fed to ‘talk about talking about tapering’ even though some Fed officials would like to begin the process. Officials at the core of the Fed — Governor Lael Brainard and New York Fed President John Williams — do not.

“We think that Powell likely agrees with Governor Brainard and President Williams that the labor market has not yet come far enough. We continue to expect the first hint in August or September, followed by a formal announcement in December and the start of tapering at the beginning of next year,” the Goldman economists said in a note.

The Fed is expected to boost its inflation forecast for this year after hotter-than-expected readings this month and last month. The consumer price index for May was up 5%. Economists are focused on the 2023 forecast, since higher inflation in the future could prompt the Fed to change its interest rate forecast as well.

The Fed watches core personal consumption expenditure inflation. The inflation forecasts that are being watched most closely are those for 2023, since it makes sense the Fed would expect to raise interest rates then if inflation persists. The Fed, so far has said the rise in inflation is temporary and results from disrupted supply chains and pent-up demand.

“It may become increasingly difficult for Powell to dismiss [inflation] as expected,” said Cabana. “He’s likely to say ‘We’re monitoring it. … We still believe it will be transitory, but we’re going to be monitoring the data very closely.'”

Cabana expects to see increases in growth and inflation forecasts for this year and next. Fed officials currently expect core PCE inflation at 2% in 2022 and 2.1% in 2023.

“How much spills into 2023 will be the real tell. Are any of these inflation pressures persistent? Do they last a couple of years? Probably not, but we’ll see,” he said. “Will the Fed pencil in a rate hike in 2023 or not? It only takes three Fed officials to shift to the rate hike camp to see that happen. We think it’s a close call, but they probably will not shift.”

The Fed presents its inflation forecast on a “dot plot,” with anonymous entries for each Fed official. In March, the dot plot showed a split of 11 to 7 against a 2023 hike. JPMorgan economists expect several Fed officials to change their position and support a 2023 hike. They also changed their own rate forecast to a rate hike in 2023.

Bank of America strategists, however, do not expect officials to agree on a 2023 hike. “We think they’ll remain in the ‘on hold’ camp, but that will be one of the key focuses of the market,” said Cabana. “The market is pricing in 2, 2.5 hikes by the end of 2023. The Fed is currently not expecting any.”

Overnight rate

Fed watchers are also split on whether the central bank will make technical adjustments to some short term rates.

Cabana expects the Fed to raise the interest on excess reserves slightly because of building pressures in the short-term lending market.

Fiscal stimulus has resulted in a large amount of funds landing in the Treasury General Account, basically the Treasury’s checking account. As the funds have been exiting the Treasury to pay for programs, it has found its way into money markets and the banking system, creating huge demand for short-term paper.

That has spurred a lot of unusually heavy activity in the overnight lending market and has driven down the rates for Treasury bills.

“On the IOER and overnight reverse repo facility, we think they will make a modest adjustment in the setting of these interest rates, [by] 2 or 3 basis points. This will be done to assure the resilience of [the Fed’s] zero rate floor and prevent money market funds from being negative,” Cabana said. “There’s really too much cash in the banking system. The banks don’t want it. They’re pushing it to money markets funds … and money funds are telling us they don’t want it either. T-bill rates are around zero. … They are all hoping for an adjustment as this meeting.”