The biggest question this week is whether the Fed’s policy-setting arm, will keep its “transitory” language with respect to inflation, says Jefferies chief economist.
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The Federal Reserve is in a jam.
Officials at the U.S. central bank are about to begin withdrawing emergency monetary support launched in response to the pandemic. Economists across Wall Street say the Fed will on Wednesday announce a $15 billion reduction in monthly Treasury and mortgage-backed securities purchases that will go into effect this month. Tapering at that pace means completion of the program by July 2022.
That’s all baked into investor expectations. What isn’t necessarily is that the Fed may have no choice but to become more hawkish at a time when U.S. economic growth is already slowing. Adding insult to injury is uncertainty around fiscal spending and taxes to pay for new programs.
The biggest question this week is whether the Federal Open Market Committee, the Fed’s policy-setting arm, will keep its “transitory” language with respect to inflation, says Jefferies chief economist Aneta Markowska. In the face of inflation that is proving much hotter and more persistent than central bankers and economists have predicted, Fed Chairman Jay Powell has remained pretty steadfast in his view that rising prices are the result of reopening bursts and therefore temporary. Markowska says the Fed will probably stick with the “transitory” script because not doing so could rattle investors and unhinge the rate-sensitive front-end of the yield curve.
But the inflation-is-transitory case is getting harder to make. Consider the Employment Cost Index released on Friday, which economists say is the preferred wage gauge given that it is a less-volatile quarterly measure that includes full compensation costs. The much bigger-than-expected surge in the third quarter ECI marked the fastest pace of increase since the inception of the series 39 years ago. Labor costs tend to be companies’ biggest expense by far, and such costs are rising quickly as millions remain out of the labor market and employers raise pay to fill a record amount of open positions.
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The acute labor shortage is the root of the everything-shortage. When the Labor Department releases its October employment situation report on Friday, economists expect to see hiring that is still lackluster and wages that are rising faster as millions of workers remain on the sidelines for myriad reasons. If labor-force participation is structurally lower than policy makers believe, it means the U.S. economy is much closer to full employment than they think and inflation has nowhere to go but higher.
Against that backdrop, some economists say the Fed is likely to drop its “transitory” inflation language this week. What’s more, says Grant Thornton chief economist Diane Swonk, “Powell said that the Fed could accelerate the tapering process if necessary to get to liftoff sooner; that is looking more probable.”
Already, investors are betting that the Fed will raise rates sooner than the central bank has communicated. Economists at Goldman Sachs last week pulled forward their liftoff forecast by a full year, to July 2022, just after tapering should conclude, citing higher inflation forecasts. “We now expect core PCE inflation to remain above 3%—and core CPI inflation above 4%—when the taper concludes,” they say, referring respectively to the Personal Consumption Expenditure index and Consumer Price Index, excluding food and energy. The former is the Fed’s favored inflation metric; historically, the central bank has sought to anchor inflation at 2%. Goldman predicts a second rate increase in November 2022 and then one every six months after that.
Markowska at Jefferies says Powell is likely to push back on rising expectations for an early liftoff, but he will have to walk a very fine line. Pushing back too hard could unhinge inflation expectations, with increased doubt among investors and consumers that the Fed will sufficiently address inflation only reinforcing pricing pressures. At the same time, not pushing back at all could unsettle the front-end of the yield curve, Markowska says, meaning inventors could start to price in earlier and more aggressive tightening.
Many observers have argued that monetary policy can’t affect supply shortages that are largely behind economywide price surges. That’s only partly true. After all, consumers are sitting on trillions of savings—a cushion that amounts to about 10% of gross domestic product—and robust demand alongside supply shortfalls has exacerbated shortages to propel inflation higher. Monetary policy is meant to affect demand, and a slowdown in this environment would in theory allow supply chains to thaw and businesses a chance to replenish inventories, in turn cooling pricing pressures.
The problem is that demand is already falling. Last week’s third-quarter GDP report reflected the slowest rate of growth since the recovery from pandemic-driven shutdowns began, as consumers pulled back, federal government spending fell, exports fell and business spending on fixed investments declined. Rising prices are one factor behind slowing consumption; it is conceivable, then, that if tighter monetary policy further slows demand and prices in turn cool, demand is reignited.
It is also possible that a recession happens along the way. As Ian Shepherdson, chief economist at Pantheon Macroeconomics puts it: ”Respectable arguments can still be made that the surge in inflation in both prices and wages will not persist indefinitely, but the danger is that the Fed could be pushed into taking action as insurance against these arguments being wrong.”
How these dynamics shake out, from the path of inflation and economic growth to monetary policy expectations and responses, depend largely on what happens with the workforce in the coming months. If millions of workers re-enter the labor force as Covid fears recede, in-person school relieves parents’ child-care struggles and fiscal benefits recede, shortages should dissipate and inflation should slow. If there is more to the story and the labor shortage is more structural than transitory, the Fed is already behind the curve—even if readings on economic growth are underwhelming.
All that is to say nothing of the trillions in federal spending still under debate by Democrats in Washington. Roughly $3 trillion in spending between two bills, one covering infrastructure and the other social spending, won’t have the impact of aid packages authorized since the start of the pandemic, says Josh Shapiro, chief U.S. economist at MFR. Child-care tax credits, the guts of the larger reconciliation bill, might help more people afford daycare and join the labor force. It’s also possible the monthly payments of up to $360 a month per child make the labor problem worse, Shapiro says.
For the Fed, it adds up to an intensifying quagmire. This week’s monetary policy statement, Powell’s press conference and October jobs report will together give investors the best reading yet on how the chips may fall.
Write to Lisa Beilfuss at [email protected]
