Fed sees rising bond yields, inflation expectations as a possible win

2/2 © Reuters. FILE PHOTO: The Federal Reserve building is pictured in Washington, DC 2/2

By Jonnelle Marte, Ann Saphir and Howard Schneider

(Reuters) - A recent rise in U.S. bond yields and market inflation expectations have bolstered Federal Reserve officials' hopes the central bank's new monetary policy approach is taking hold and could be further buoyed if a Democratic-led Congress rolls out more spending.

"I am encouraged to see the rise in market indicators of inflation expectations. ... That is what we are trying to support," Richmond Federal President Thomas Barkin said on Thursday in an interview with Reuters.

Barkin said he regarded a recent rise in interest rates on Treasury bonds as also part of a "reflation trade," a sign that investors were factoring future hikes in prices into their decisions by demanding higher interest rates, rather than representing a worrisome tightening of financial conditions.

"The ingredients for higher inflation are in place," St. Louis Fed President James Bullard said in separate comments to reporters. "You have very powerful fiscal policy in place and perhaps more to come," with Democrats now about to control the White House as well as the U.S. Senate and House of Representatives.

"You have a Fed that ... wants to temporarily have inflation above target. You have the economy poised to boom at the end of the pandemic," once the impact of new coronavirus vaccines is felt, Bullard said. The yield on the benchmark 10-year Treasury rose above 1.07% on Thursday, hitting its highest level since March. The 5-year forward inflation expectation rate hit nearly a two-year high of 2.05%.

'INCREDIBLY DISAPPOINTING'

After nearly two years of study, the Fed in August changed its approach to monetary policy to allow for higher inflation, hoping to meet its 2% target on an average basis by letting prices drift higher for some time in order to offset years in which inflation had been weak.

That would also allow, in theory, a lower unemployment rate since the central bank would try to sustain the sort of "hot" economy that leads to rising prices.

The massive uncertainty about the economy and the course of the pandemic late last summer has since given way to what Barkin said was more "clarity" around where things stand - with two coronavirus vaccines being distributed, fiscal buffers in place to help many American households, and consumers "not far away" from the point when they will "engage in the economy with a lot more confidence."

The pace of the vaccine distribution will play a large role in when that happens, with some policymakers expressing dismay at the effort so far.

Philadelphia Fed President Patrick Harker called the early U.S. vaccination figures, with fewer than 5 million inoculated so far, "incredibly disappointing."

But the events of the last few weeks do seem to have shifted market bets about the future, with trades in inflation-linked securities hinting investors expect higher inflation and accept the Fed will not stand in the way of it.

"We are looking at a long period where the fed funds rate will stay at essentially zero," Harker said, referring to the central bank's key overnight interest rate. He added that he saw no signs that "inflation is going to go out of control."

Indeed, Chicago Fed President Charles Evans expressed more skepticism about the inflation to come, even with the additional government stimulus that might be on the way to help battle the economic fallout of the pandemic and the recession it triggered.

The boost to inflation from added fiscal spending, he told a bankers group on Thursday, is not "nearly as strong as I would like." He said he believes inflation won't reach 2% until 2023, and that it would not be unreasonable for the Fed to wait until mid-2024 before raising short-term rates from their current near-zero levels.

San Francisco Fed President Mary Daly, in an event Thursday put on by the Manhattan Institute's Shadow Open Market Committee, said she believes a stronger labor market will eventually give rise to higher inflation, though the upward push on prices from a tight job market is likely weaker than it was in the past, making a sudden surge unlikely.

That means, she suggested, the Fed can allow the job market to strengthen further than it might have in the past.

At the same time, Daly said she was reassured by a recovery in inflation expectations, which showed market participants, households and businesses are beginning to believe the Fed will deliver on its aim to overshoot 2% inflation.