It's a big week for the US Federal Reserve – and for markets

Various central banks have meetings this week, including the Bank of England and the Bank of Japan. But the biggie, as always, is America's central bank, the Federal Reserve. It has a very tricky tightrope to walk this time around.

We've been talking about inflation, the bond markets, and market perceptions of what'll happen next a lot in the last few Money Mornings. But that's because it's important.

Of all the things that are likely to trigger the next correction in markets, a confrontation between markets and central banks is the most obvious.

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Why the taper tantrum could be repeated

We saw this in 2013, with the “Taper Tantrum”. What happened back then is that the US was (finally) coming out of the financial crisis and then-Federal Reserve governor Ben Bernanke hinted that it might be time to unwind quantitative easing (QE). Markets promptly threw a wobbly. Bernanke either back-tracked – or “clarified”, depending on how you prefer to put it – and markets regained their composure. Eventually QE was unwound, but at an incredibly gentle pace.

The core point was always for the Fed to lag behind the markets – to always be less aggressive than the markets expected, and to make sure that markets knew they'd be there to catch them the minute they fell. That “gently does it” approach continued into Janet Yellen's time at the top of the Fed.

Yellen eased markets into the idea that interest rates would start to rise. When Jerome Powell took over from her, he continued to raise rates through 2017 and 2018. But he eventually pushed markets to the point where they thought he was moving too fast. As a result, in early 2019, he cooled off and then in mid-2019, started lowering rates again.

Powell has learned his lesson – to an extent. He's not planning to rattle markets again with any “hawkish” lines. He's been very clear that the Fed is not fazed by inflation and expects rates to stay low for a long time. However, this won't cut it anymore. Markets are looking at all the stimulus getting pumped into the economy, particularly in the US, and they think that inflation and a strong rebound in growth is on the way.

That's one reason why bond yields have been rising, and why some have even declared the lengthy bond bull market to be definitively over. Indeed, according to Bloomberg, as measured by at least one popular bond exchange-traded fund (ETF), the iShares 20-plus Year Treasury Bond ETF, bonds are now in a bear market (as measured by a drop of 20% from the most recent high).

So far Powell's approach has been one of: “Nothing to see here, folks”. He's not really addressed the rise in bond yields or inflation expectations, trying to stick to the view that he'll look through them.

That's not sustainable.

The Fed needs to draw a line in the sand or markets will force its hand

The problem now is that markets simply don't believe the Fed's view of things. Powell and the Fed don't think that inflation will rise sharply enough to require any tightening of monetary policy in the near future.

Markets are saying that they think this scenario that he's presenting is wrong. They think something different is going to happen. In effect, markets are telling the Fed: “You're wrong. Inflation is going to rise more quickly than you think. As a result, you're going to be pushed into raising interest rates more quickly than you think. And this is what we're pricing in.”

Powell may genuinely think that markets are wrong on this. He's entitled to his view. It seems equally likely to me that what he really means is that even if markets are right to think that inflation is going to go up faster than he's predicting, it doesn't necessarily follow that interest rates will go up too.

However, he hasn't made that clear enough to force markets to sit back down.

What markets really want to hear is: “Look, even if you lot are right – and I think you're wrong – we'd ignore inflation anyway.” And they want him to set parameters on that.

But the reason he hasn't made it clear goes back to what we said on Friday about the European Central Bank: it's difficult for a central bank to out-and-out admit that it's going to run the economy hot. Or more explicitly, that it's going to ignore inflation, certainly until it becomes politically untenable to do so.

I suspect that we're now reaching the point where the market will force the issue. There are a couple of classic ways out for the Fed from here.

One, it can change the target in a non-official but pretty explicit manner. When the 2013 tantrum happened, Bernanke shifted focus to the unemployment figures, and indicated that the Fed would want unemployment to drop to a certain level before it even considered tightening monetary policy. That's definitely an option and it seems like a good one to me, given that the Fed's mission has already been changed along these lines, to make employment the main focus.

The second classic is to rely on the fact that bond yields rising in themselves tighten monetary policy. If the Fed feels that rising bond yields jeopardise the recovery by tightening financial conditions, then the central bank can push back against that too.

Neither of these options involves explicitly saying: “We won't raise rates until inflation is at 5% or above sustainably” but both of them make it clear to markets that it's time to back off.

If we don't get a message with that sort of clarity on Wednesday (in the evening, British time), I suspect that the pace of the bond sell-off would pick up and we would probably see some spillover into stockmarkets. I think the Fed would then feel forced to act more aggressively to put a floor under things.

As a long-term investor, you don't have to worry about these bumps along the way. But make sure you have your eyes on any assets you might be keen to buy at cheaper prices, because it's possible that the Fed will create an opportunity to do so later this week.

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