The Fed's policy outlook is unclear, and market sentiment is seriously uneasy under high inflation

The Fed will release new economic projections after a two-day meeting on Wednesday, with the first rate hike likely to come in 2023. Economists do not expect the Fed to take any policy steps for now, but it could signal to markets that it is considering changing its original bond-buying plan.

The Fed may not release too many details about the tapering plan for this conference, but someone will definitely mention the issue, and the Fed may give a clearer answer later this summer. The Fed should not take any action for the time being, but it may send a signal that it is considering providing a solution.

Stock futures were flat Wednesday morning as investors awaited the Fed's statement at 2 pm ET and the chairman's press conference 30 minutes later.

Some economists expect the Fed to mention the upcoming reduction in its bond-buying program and give initial guidance on the discussion, but not to make a full commitment to tapering. The Fed will also release new economic forecasts as usual.

The market generally believes that the Fed is likely to raise interest rates for the first time in 2023. In previous forecasts, Fed officials did not reach a consensus on raising interest rates before 2023.

Rick Rieder, chief investment officer of global fixed income at BlackRock, told CNBC, "I think this press conference will be very interesting. There is obviously a disagreement between the board and the Fed chairman on the strength of the economy, and the highlight will be the evolution of subsequent policies."

U.S. Federal Reserve Chairman Jerome Powell tells reporters after the Fed cut interest rates during a news conference in Washington, March 3, 2020, that the Fed's rate cut was an emergency move to protect the world's largest economy from the impact of the coronavirus.

At the last meeting, some Fed officials noted that it might be more appropriate to begin discussing plans to adjust the pace of bond purchases if the economy continues to make progress, according to the minutes.

Some economists said discussions on the issue could begin this week, but only at a preliminary level. The real details of tapering the $120 billion in monthly purchases are expected to come later this year. Many economists expect formal discussions to take place in late August, when the Fed holds its annual symposium in Jackson Hole, Wyoming. The Fed could then begin unwinding its bond-buying program by the end of this year or early next, they said.

"This week's message is likely to contain plenty of 'there's still a long way to go' rhetoric sprinkled with concerns about upside risks to inflation," Barclays economists wrote in a note. "We don't expect the debate on taper to be vigorous, but just starting the discussion and expressing concerns about strong inflationary impulses will have a hawkish tone."

James Gorman, CEO of Morgan Stanley, also expressed his views on the Fed's interest rate hike prospects and inflation in an interview with CNBC. "It is important to reduce the bond program because once its so-called quantitative easing policy ends, it indicates that the Fed will embark on the path of final tightening policy, that is, raising interest rates. The Fed began buying Treasury bonds and mortgage securities last year as a way to provide liquidity when the economy stagnated during the epidemic. Once the Fed begins to reduce purchases, it may take several months to complete. When it reaches zero, then the door to the Fed's interest rate hike will be open. The Fed's loose policy is believed to have fueled the stock market's rebound, pushing it to new highs, and creating an environment for strong development in the real estate market."

Mark Cabana, head of U.S. short-term rate strategy at Bank of America, said, "We don't expect any major policy changes from the Fed. Most of the conversation will be around the qualitative nature of the tapering, what the Fed says about it, and the impact of the adjustments in the Fed's forecasts. Regarding the balance sheet reduction, we think they will start talking about it. We expect Powell to reiterate the Fed's position that 'this is still a while'."

But Goldman Sachs economists said it was too early for the Fed to 'talk about tapering,' even though some Fed officials want to start the process. Core Fed officials, Governor Lael Brainard and New York Fed President John Williams, hold different views. "We think Powell is likely to agree with Governor Brainard and Chairman Williams that the labor market has not gone far enough. "We still expect the first hint in August or September, followed by a formal announcement in December and the start of tapering early next year," Goldman Sachs economists said in a note.

The Federal Reserve is expected to raise its inflation forecast for this year after higher-than-expected CPI readings this month and last. The Consumer Price Index (CPI) rose 5% in May. Economists are focusing on the 2023 forecast, as higher inflation in the future could force the Fed to change its rate forecasts or even policy. But so far, the Fed has said the rise in inflation is temporary, caused by supply chain disruptions and a short burst of pent-up demand.

Cabana mentioned that “it may become increasingly difficult for Powell to dismiss [inflation] risks as expected, and he may say ‘We’re monitoring it. … We still think it’s going to be transitional, but we’re going to monitor the data very closely.’ We’re going to see an increase in market growth and inflation forecasts this year and next. Are any of these inflationary pressures persistent? Will they last for several years? Probably not, but we’ll see,” he said. “Will the Fed raise rates in 2023? It only takes three Fed officials to switch to the rate hike camp to see that happen. We think it’s a close call, but they may not switch.” Fed officials currently expect core PCE inflation to be 2% in 2022 and 2.1% in 2023.

The Fed displays its inflation forecasts on a "dot plot," in which each Fed official has an anonymous vote. In March, the dot plot showed an 11-to-7 split against a 2023 rate hike. JPMorgan economists expect several Fed officials to change their stance and support a 2023 rate hike.

However, strategists at Bank of America do not expect officials to agree to a rate hike in 2023. "We think they will continue to maintain their 'hands off' strategy, but this will be one of the key focuses for the market."

Fed watchers are also divided over whether the central bank will make technical adjustments to some short-term interest rates.

Cabana expects the Fed to slightly increase the interest it pays on excess reserves (IOER) as pressures in short-term lending markets continue to build. The fiscal stimulus has caused a lot of money to flow into the Treasury General Account, which is the Treasury's checking account. As money has flowed out of the Treasury to pay for projects, it has found its way into the money markets and the banking system, creating a huge demand for short-term bills. This has simultaneously stimulated activity in the overnight lending market and pushed the interest rate on Treasury securities down. "Regarding IOER and the overnight reverse repo facility, we think they will make a modest adjustment to the setting of those rates, [reducing] by 2 or 3 basis points. This will be to keep the [Federal Reserve's] zero interest rate floor flexible and prevent money market funds from going negative. There is really too much cash in the banking system. Banks don't want it. They are pushing it to money market funds... and money funds are telling us they don't want the cash either. T-bill rates are around zero. ... They all want some adjustments at this meeting."