Some Fed officials appear to be wavering on a recent policy shift to let run inflation run hot while it pursues maximum employment. Here, a business in Queens, N.Y., advertises for help on a recent day.
Spencer Platt/Getty ImagesIt has been nine months since the Federal Reserve committed not to raise short-term interest rates “until labor market conditions have reached levels consistent with the committee’s assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.” The Fed has since reiterated that pledge at each of its policy meetings, including the most recent one in mid-June.
But some Fed officials don’t seem to be on board with what they’ve signed up for, putting both the expansion and the central bank’s credibility at risk.
The Fed’s pledge was a significant policy shift. Instead of promising to pre-emptively slow the economy to keep inflation under control as it had in the past—most recently in 2014-18—the Fed was telling investors that it was willing to wait until well after the economy had fully recovered before tightening financial conditions.
The commitment was meant to be consistent with the Fed’s new monetary strategy, which is based on the idea that prices should rise 2% a year on average over time. That may not sound like much of a change from the Fed’s previous 2% inflation target, but the key implication is that “appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time” if “inflation has been running persistently below 2%.”
The language is ambiguous, but the Fed’s preferred measure of prices has grown less than 1.6% a year on average since the beginning of 2011, which implies that the Fed could conceivably tolerate inflation averaging around 2.4% each year through the end of the decade before getting concerned. In practice, even that outcome would require the Fed to be comfortable with sustained periods of inflation closer to 3%, as Barron’s explained back in February, which would be necessary to balance out other periods when inflation might come in closer to 2%.
The question has always been whether the Fed would be willing to accept the implications of its new framework when faced with a test. It’s easy enough to commit to tolerating a faster pace of price increases when inflation isn’t on the horizon, but it’s something else to ask central bankers trained for decades to reject inflation to just sit by and do nothing when prices are rising at their fastest pace in decades. So far, it looks as if a sizable chunk of Fed officials are unwilling to follow through on their commitments.
The Fed’s summary of economic projections shows what officials think will happen to growth, unemployment, inflation, and interest rates under “appropriate monetary policy.” It’s an expression of officials’ desires as much as a forecast. At the end of 2019, officials thought prices would rise about 2% each year from 2020 to 2023. As it turned out, prices rose just 1.2% in 2020. The latest projections show that officials think prices will rise a bit more than 3% in 2021, thanks to one-off factors associated with the pandemic, after which inflation will return to about 2% a year from 2022 to 2023. In practice, this means that the current medium-term inflation outlook under “appropriate monetary policy” is almost identical to what it was before the Fed adopted its new framework.
Yet many officials’ projections also assume that interest rates will be rising over the next few years. There are seven Fed officials planning to raise rates at least once in 2022. The presidents of the Federal Reserve banks of Atlanta, Dallas, and St. Louis have recently gone on record saying they want to begin raising interest rates as soon as 2022 to keep inflation under control, with more increases in 2023.
Those policy makers think financial conditions need to be tightened to prevent inflation coming in faster than 2%, even though that means they would be rejecting the Fed’s new average inflation framework. At least some of those officials would also be rejecting their pledge not to raise rates before returning to “maximum employment,” since there are only three members of the Fed’s rate-setting committee who expect the jobless rate to be lower than it was before the pandemic by the end of next year.
While the majority at the Fed may still be committed to the official line—including, crucially, Chairman Jerome Powell, Vice Chairman Richard Clarida, and governor Lael Brainard—the presence of a restless and potentially dissenting faction is starting to have an effect on market prices.
The Minneapolis Fed estimates the implied probabilities that investors are assigning to various inflation outcomes by comparing the prices of derivatives known as caps and floors. In early May, traders thought there was a 45% chance that the consumer price index would rise by more than 3% a year on average over the next five years. That would have been broadly consistent with the Fed’s new framework, considering that the CPI tends to run faster than the PCE price index preferred by the Fed. Since then, however, those implied odds have dropped down to 30%, which is lower than in 2012.
Similarly, the break-even CPI inflation rates that make investors indifferent between conventional U.S. Treasury securities and their inflation-protected equivalents suggest limited confidence that the Fed’s new framework means much. The break-even inflation rate for the next five years is just 2.5%, which isn’t much different from 2012 and probably consistent with PCE inflation of about 2.1%. The average break-even rate for the five years after that is just 2.2%, which is lower than in 2018. Only the longer-term inflation break-even rates imply that anything may have changed.
The Fed’s internal disagreements are only going to become more important for investors as the economy recovers and the central bank transitions from crisis-fighting to conventional cyclical management. The gap between those who want to pre-emptively raise interest rates and those who don’t will only become more pronounced if the current burst of inflation dissipates next year—as most Fed officials expect. Abandoning the new framework should be bullish for fixed income and bearish for inflation-sensitive assets such as precious metals.
Note to readers: This is going to be my last column for Barron’s. I’ll soon be launching an independent subscription service. If you want to be added to the list, please email me at mattkleinpostbarrons@gmail.com
June 26, 2021 at 02:30AM
https://www.barrons.com/articles/old-inflation-fighting-habits-die-hard-for-some-fed-hawks-51624649401
Old Inflation-Fighting Habits Die Hard for Some Fed Hawks - Barron's
https://news.google.com/search?q=hard&hl=en-US&gl=US&ceid=US:en
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