A Taper Tantrum Could Follow This Inflation Spike
(Bloomberg Opinion) -- The Federal Reserve tried so hard to avoid a repeat of the 2013 “taper tantrum” — and was so successful in doing so — that it might just end up backfiring in a big way.
Just a week after the central bank announced that it would begin scaling back its $120 billion of monthly bond purchases at a pace that would last eight months, Labor Department data showed the U.S. consumer price index soared by 6.2% in October from a year earlier, the fastest annual pace since 1990. It advanced 0.9% just from September, the steepest increase in four months. Meanwhile, the core measure that excludes volatile food and energy prices jumped to 4.6%. Fed Chair Jerome Powell acknowledged at his press conference last week that “the level of inflation we have right now is not at all consistent with price stability.” So, what would he say about this latest reading?
In truth, there’s not much he or other Fed officials can really say, except to stick to their line that they expect this level of inflation will ultimately prove to be transitory and fade around the middle of next year. Indeed, San Francisco Fed President Mary Daly said after the CPI report that it’s “premature” to change the calculation about raising interest rates. It’s hardly a coincidence that the central bank’s projected timeline of fading inflation pressure aligns perfectly with its current course of winding down asset purchases.
The problem, as my fellow Bloomberg Opinion columnist Conor Sen noted on Twitter, is that the Fed and the Biden administration have gotten their inflation calls entirely wrong this year. Price growth has lasted longer than expected. And, crucially, they’re no longer able to point to obvious reopening quirks as the reason for elevated inflation. “The really scary thing is that I’m looking for a big outlier,” Michael Ashton, also known as “Inflation Guy,” said on Twitter. “And I can’t really find one.” Bloomberg Economics doesn’t see headline CPI peaking until possibly January.
Typically this kind of widespread inflation concern, when the labor market is tight by many measures, would call for a policy response. But what’s the Fed to do? Powell has made it clear that the central bank won’t raise interest rates while it’s still buying bonds. Traders shouldn’t even link tapering and rate increases, he has said, because the latter requires a more stringent test.
The only policy lever that the Fed can pull right now is to accelerate the reduction of its asset purchases. But there’s good reason to believe that such a move would unnerve people, potentially causing — wait for it — a taper tantrum.
Think about the message that such a shift would send to markets. First, it would undermine the central bank’s stance that tapering and rate increases are entirely separate — the clear implication of speeding up would be that the Fed needs to quickly get to a place where it could raise interest rates to address price pressures. Second, it would be an implicit acknowledgment from Powell and his colleagues that they were wrong about inflation being transitory, raising doubts about their ability to contain it. That, in turn, could push expectations for the coming years even higher.
The front end of the U.S. Treasury market is already showing signs of throwing a tantrum. Two-year yields shot higher by about 9 basis points after the CPI report, the biggest one-day move since 2019 when excluding the volatile swings during the worst of the Covid-19 crisis. Five-year yields rose even more, jumping 10 basis points and flattening the curve out to 30 years to just 68 basis points, the lowest since March 2020. While there’s still a ways to go before it inverts — the classic sign of an impending slowdown — it’s starting to seem as if bond traders are pricing in a Fed that will need to aggressively tighten policy to halt inflation pressure, even if it chokes growth.
For those who believe the Fed is hardly immune to politics, it might seem like a hawkish shift would be highly unlikely ahead of crucial midterm elections a year from now. But it’s equally possible that surging inflation is even more problematic for President Joe Biden and other Democrats. He said on Wednesday that reversing inflation is a top priority, and that it’s up to an independent Fed to “take steps necessary to combat it.” Democratic Senator Joe Manchin of West Virginia, meanwhile, said on Twitter that “Americans know the inflation tax is real and DC can no longer ignore the economic pain Americans feel every day.”
Fed officials may attempt to satisfy these concerns by using their “dot plot” of expected interest-rate increases, which will be updated after next month’s Federal Open Market Committee meeting. Right now, policy makers are split between raising interest rates or leaving them unchanged in 2022. After the latest data, the median will almost certainly move up to project one rate increase. Two might be a stretch.
That kind of signaling, without actually doing anything, was policy makers’ playbook from June, when they surprised markets by penciling in two rate hikes in 2023. That might not be enough to quell inflation concerns this time around.
The most likely outcome remains that the Fed will avoid flinching, hold tight to its new policy framework and hope that supply-chain bottlenecks will resolve themselves enough by June that inflation will come down and it can start to gradually raise interest rates in the second half of next year. But Wednesday’s CPI data raises the risk that the temperature in Washington will be too high to stay the course for that long, leaving the Fed with little choice but to speed up tapering at some point in early 2022.
If that happens, look out for Taper Tantrum 2.0.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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