The Fed’s Taper Talk is a preemptive strike against inflation fears

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Inflation readings are hotter than expected by Federal Reserve officials and could accelerate as they debate scaling back on their massive bond-buying campaign.

Fed vice-chairmen Randal Quarles and Richard Clarida both said this week that policymakers could start this discussion at “upcoming meetings.” This echoes a line from the minutes of the Fed’s April meeting, but carries more weight coming from President Jerome Powell’s management team.

Clarida called April’s consumer price report a “bad surprise.” On Friday, a key indicator of the Fed’s target prices rose 3.6% from a year earlier, the largest increase since 2008.

“We’re talking about the phase-out,” San Francisco Fed President Mary Daly told CNBC. interview on May 25, while warning that there was no plan to do anything at this time.

The post-pandemic economic growth spurt, which has pushed up prices for everything from bicycles to lumber, has put Fed officials on high alert.

While calling inflation “transient,” they are also starting to question whether a slow reaction from the supply side – the millions of businesses and people who make things and provide services – could lead to several quarters of decline. High inflation readings that are starting to creep into consumer psychology.

“Inflation will be 2.5% or more this year – mostly temporary – but inflation may well be above 2% next year,” said former Fed Governor Laurence Meyer, who said. sees decrease from December. “Risk management may be necessary to prevent inflation expectations from climbing higher, which would not be easily reversible.”

The public conversation officials are having about the phase-out is a surprising change as just a month ago, Powell was skeptical that inflation or real expectations would rise on a lasting basis “when there is still had a significant downturn in the labor market ”.

Inflation expectations

“The fear they have is that this will be built into inflation expectations,” said William English, a former Fed economist. “There is huge uncertainty and models that look at history to inform your forecast are much less useful because we have no history of anything like this.”

The risks are double-sided, said English, now a professor at the Yale School of Management, as a fear of inflation could also cause officials to slow the recovery too aggressively and slow the recovery, especially if the budget support decreases.

The agility of Fed officials is now a testament to former President Alan Greenspan’s view that risk management was essential because the structure of the economy is always changing.

Asset purchases are the most flexible tool the Fed currently has, as they can be gradually adjusted if necessary. Raising interest rates, currently close to zero, is a much bigger decision.

Meyer said there would be a “serious discussion” on when to phase out. “They can’t preemptively raise rates in the new framework, but they can preemptively decrease,” he said, referring to the Fed’s August move to an average inflation target of 2% and its commitment to focus on broader labor market measures. soft.

Price pressures

Forecasters polled by Bloomberg estimate that the PCE price index, the Fed’s preferred inflation gauge, will rise 2.5% in 2021 – about a percentage point higher than what Fed officials had estimated one year ago. Producer prices rose 6.2% in April from a year ago, with the largest amount of data going back to 2010.

Fed officials say the surge in prices is to be expected as the economy reopens amid pent-up demand, and is expected to prove temporary as supply problems ease. But executives say they have so little clarity on what the future will bring them that it doesn’t make sense to add new capabilities.

US steelmakers are enjoying windfall profits with steel prices at record highs. But none of this has encouraged companies to announce new plans to build more factories and hire more workers. US Steel Corp. did the opposite, last month canceling a $ 1.3 billion spending plan to rehabilitate a factory that dates back to Andrew Carnegie and announcing it had no plans to reopen two highs stoves closed during the last 15 months. Stocks jumped on the news.

The lumber industry is also instructive. Fueled by low Fed rates, homebuilding has emerged from the pandemic. North American softwood sawmill capacity increased by 1.4 billion board feet last year, says American Wood Council mentionned. But when it comes to expanding further the “times to get new equipment” can take until two years, the group said.

Compensation of U.S. workers in the private sector accelerates with wider reopening of the economy

Signs of emerging cost pressures are also developing on the labor side of the inflation equation. The Ministry of Labor’s first quarter employment cost index report showed the largest quarterly increase in workers’ compensation in companies since 2003.

Read more: Inflation brews for US producers as service wages rise

Business models, and humans in general, like to draw smooth lines and curves to describe the future. But consider this trend in light of the irregular peaks and troughs in data caused by the pandemic.

The household savings rate is up by around 30% of disposable income. Fed staff preparing a forecast for the June 15-16 meeting must decide how quickly this money will be spent. Labor force participation is down almost two percentage points with a notable withdrawal of women and aged 55 and over. How fast are they coming back?

“No one has a crystal ball, but it is certainly possible to describe a few alternative scenarios,” said Andrew Levin, professor at Dartmouth College. “What the Fed needs is a robust strategy that avoids getting caught up in mistaken judgment about how the economy is doing.”

Market implied inflation expectations in the US have fallen most since 2020

Reducing asset purchases may tighten financial conditions, but the most significant impact will likely be to bring investors’ inflation expectations under control. So far, various market-based measures appear to be stable.

But for households, the impact of the reduction on the psychology of inflation is much less obvious, says Michael Weber, an economist at the Booth School of Business at the University of Chicago.

Weber said that households have an inherent inflation bias in that they notice more when prices go up than when they go down. Until the pandemic, inflation was so low and stable that households just didn’t pay much attention to it. Now, with the rise in the prices of goods and services, they have new information, and the risk is that they will start to form new expectations.

“If businesses and households have increased inflation expectations, realized inflation will follow,” Weber said. “They will negotiate for higher wages.”

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