Jerome Powell

Federal Reserve Chair Jerome Powell could find himself in a tough spot this week, having to defend his ultra-easy monetary policy outlook amid a quickening economic recovery thats ignited fears of inflation.

The Fed wraps up its two-day policy meeting on Wednesday, almost exactly 12 months after slashing interest rates to nearly zero as Covid-19 spread. It will publish its policy statement and quarterly forecasts at 2 p.m. in Washington, with Powell holding a press conference 30 minutes later.

A lot has changed in the three months since the Fed last published economic projections, including massive fiscal stimulus and accelerating vaccinations. Thats creating a growing gulf between traders expectations on interest rates and what the central bank is signaling itll do in coming years.

Powells spent recent weeks trying to dispel premonitions about impending tightening, and hell be asked to reconcile a likely upgrade to the Feds economic outlook and its projects that are expected to show zero interest rates through 2023.

I think this is kind of a meeting the Fed would rather not have, said Ethan Harris, Bank of America Corp.s head of global economic research. For this meeting, the big problem that they face is that they have to raise their forecasts — the GDP forecast they have right now is so stale it could be carbon-dated.

The Fed last updated its

projections in mid-December, before broad distribution of vaccines and almost $3 trillion in fiscal aid was signed into law.

Economists surveyed by Bloomberg expect Fed officials to upgrade their 2021 economic-growth forecast to a median 5.8% from 4.2%. Thats still below some of the most bullish Wall Street estimates.

Goldman Sachs Group Inc. is calling for a 7.7% increase in the same period and 11 other firms tracked by Bloomberg say growth will be at or above 7% at the end of the year.

The better outlook has raised market

expectations for future inflation and prompted investors to sell bonds, pushing up yields and renewing skepticism that Powell can keep rates low for as long as the Fed has indicated.

But the Fed chief is sticking to his guns, arguing that the economy has a long way to go in fully getting back to where it was before the pandemic. Hes reiterated that the central banks new policy strategy means itll focus more intently on returning to maximum employment, and will judge that in a much broader way than before.

Dot Plot

Investors will be scrutinize the so-called dot plot, which summarizes the interest-rate projection of each U.S. central banker over the next three years and in the longer run.

In December, it showed that all policy makers expected rates to remain in their current zero to 0.25% range this year. One person saw a rate hike in 2022 and five participants saw increases in 2023. That firmly left the median of the projections expecting no hike on the forecast horizon.

Although 75% of economists in a Bloomberg survey said the Fed will have to raise rates by the end of 2023, they didnt see a change to the Feds median 2023 projection at this months meeting. Interest-rate futures, however, are pricing in about three 25 basis point rate increases before the end of that year.

A change — or near-change in the Feds median 2023 dot if a few more of the 18 officials marked up their projections — could be a way to assuage markets, giving them some indication that policy makers see things improving, without Powell having to be too explicit on the timing of policy tightening.

This is a market that craves calendar guidance in some way and the Fed has set this up, that its outcome based, said Brett Ryan, senior U.S. economist at Deutsche Bank AG. Its just too soon to really make firm commitments to a tapering time line, but if you put in a hike in 2023 you at least give some sense of a time line for the market.

Read More: Powell Likened Dot-Plot Dangers to Nuclear Meltdown in 2014

The Feds dot plot has sometimes contributed to market volatility, something Powell is keenly aware of. He said in late 2019 that its a challenge to get people to properly understand it.

Recovery optimism reflects a sense that activity will bounce back quickly in the second half of the year as more widespread immunity to Covid-19 unlocks a spending flurry.

Hiring has already picked up, with more than half a million jobs created in the first two months of 2021, and some see that improvement accelerating. But as Powell pointed out earlier this month, nearly 10 million Americans remain jobless. The Black unemployment rate rose to a staggering 9.9% last month.

Inflation also hasnt reflected much of a recovery yet. Stripping out more-volatile food and energy prices, the consumer price index edged up 1.3% in February, far from the Feds 2% target. Economists expect bigger gains in the coming months, both due to transitory pandemic-related effects and things like higher gas prices and increased spending on leisure activities following a year of lockdowns.

Whats priced into markets is quite a lot of inflation for 2021. That hinges on a narrative of the economy reopening and creating a big burst of inflation, said Laura Rosner, a partner at MacroPolicy Perspectives LLC in New York. Were a little bit more cautious, we dont expect quite as much inflation as the market is expecting.

Powell last year unveiled a new policy framework, saying theyll allow inflation to overshoot 2% after periods below it. Thatll likely mean the Fed will keep policy accommodative for longer.

But if the quick and powerful recovery that bond traders are betting on materializes, it could cause a more disorderly sell off in Treasuries, threatening stable financial conditions, which the Fed wants to avoid.

In the meantime, Powell and his colleagues have indicated theyre not worried about the recent rise in Treasury yields, saying that as long as such price moves are driven by the right reasons — such as the stronger economic outlook — its not a concern.

Higher bond yields are part of the Feds plan, Harris said. The whole idea here of what theyre doing right now is to get the economy hot, get inflation above target, get the unemployment rate back down to where it was in 2019 when you had a hot labor market and, then at that point, start hiking.

With assistance by Vivien Lou Chen, and Rich Miller

    Before it’s here, it’s on the Bloomberg Terminal.