Fed’s Taper Talk Is Pre-Emptive Strike Against Inflation Fears
Inflation readings are coming in hotter than Federal Reserve officials expected and could accelerate the timing of when they debate scaling back their massive bond-buying campaign.
Fed Vice Chairs Randal Quarles and Richard Clarida both declared this week that policy makers could begin this discussion at “upcoming meetings.” That echoes a line from minutes of the Fed’s April gathering but carries more weight coming from Chair Jerome Powell’s leadership team.
Clarida called April’s consumer prices report an “unpleasant surprise.” On Friday, a key gauge of prices targeted by the Fed rose 3.6% from a year earlier, the biggest jump since 2008.
“We are talking about talking about tapering,” San Francisco Fed President Mary Daly said in a CNBC interview on May 25, while cautioning that there were no plans to do anything now.
The post-pandemic economic-growth surge, which has pushed up prices on everything from bicycles to lumber, has Fed officials on alert.
While calling inflation “transitory,” they are also starting to wonder whether a slow response by the economy’s supply side -- the millions of companies and people who make things and provide services -- could result in several quarters of high inflation readings that start to creep into consumer psychology.
“Inflation will be 2.5% or higher this year -- mostly temporary -- but inflation could well be above 2% next year,” said former Fed Governor Laurence Meyer, who sees them tapering as soon as December. “Risk management may be called for to avoid inflation expectations creeping upward, which would not be easily reversible.”
The public conversation officials are having about tapering is a surprising shift because only a month ago, Powell was skeptical that actual inflation or expectations would move up in a lasting way “while there was still significant slack in the labor market.”
“The fear they have is that this gets built into inflation expectations,” said William English, a former senior Fed staff economist. “There is tremendous uncertainty and the models that look at history to inform your forecast are much less useful because we have no history of something like this.”
Risks are two-sided, said English, now a professor at the Yale School of Management, because an inflation scare could also cause officials to reel in stimulus too aggressively and slow the recovery, especially if fiscal support wanes.
The agility Fed officials are showing now hearkens back to former Chair Alan Greenspan’s view that risk management was essential because the economy’s structure is always shifting.
Asset purchases are the most flexible tool the Fed has now because they can be gradually adjusted as necessary. Raising interest rates, currently near zero, is a much more momentous decision.
Meyer said there will be a “serious discussion” about the timing of tapering. “They can’t raise rates pre-emptively in the new framework, but they can taper pre-emptively,” he said, referring to the Fed’s August shift toward average 2% inflation targeting and a commitment to focus on broader measures of labor market slack.
Forecasters surveyed by Bloomberg estimate the PCE price index, the Fed’s preferred inflation gauge, will rise 2.5% in 2021 -- about a full percentage point higher than Fed officials estimated a year ago. Producer prices rose 6.2% in April from a year ago, the most in data going back to 2010.
Fed officials say the price surge is to be expected as the economy reopens amid pent-up demand, and should prove temporary as supply glitches abate. But executives say they have such little clarity about what the future will bring that it doesn’t make sense to add new capacity.
American steelmakers are enjoying stellar profits with steel prices at record highs. But none of this has encouraged companies to announce new plans to build more plants and hire more workers. U.S. Steel Corp. actually did the opposite, last month scrapping a plan to spend $1.3 billion rehabilitating a mill that dates back to Andrew Carnegie and announcing it has no intention to re-open two blast furnaces closed in the last 15 months. Shares surged on the news.
The lumber industry is also instructive. Fueled by the Fed’s low rates, home construction surged out of the pandemic. North American softwood sawmill capacity increased by 1.4 billion board feet in the last year, the American Wood Council said. But when it comes to expanding further “lead times to get the new equipment” can take up to two years, the group said.
Signs of emerging cost pressures are also developing on the labor side of the inflation equation. The Labor Department’s first-quarter employment cost index report showed the biggest quarterly increase in worker pay at companies since 2003.
Economic models, and humans generally, like to draw smooth lines and curves to describe the future. But consider that tendency in light of the jagged peaks and valleys in the data caused by the pandemic.
The household savings rate is up around 30% of disposable income. Fed staff preparing a forecast for the June 15-16 meeting need to decide how quickly that money gets spent. Labor-force participation is down nearly two percentage points with a notable exit by women and those aged 55 and over. How fast do they return?
“No one has a crystal ball, but it’s certainly possible to describe a couple of alternative scenarios,” said Andrew Levin, a professor at Dartmouth College. “What the Fed needs is a robust strategy that avoids getting locked into an incorrect judgment about how the economy is evolving.”
Dialing back asset purchases may tighten financial conditions, but the most significant impact is likely to be on keeping investors’ inflation expectations in check. So far, various market-based measures look stable.
But for households, the impact of tapering on inflation psychology is much less obvious, says Michael Weber, a University of Chicago Booth School of Business economist.
Weber said households have an intrinsic inflation bias in that they notice more when prices are going up than when they are going down. Until the pandemic, inflation was so low and stable that households simply weren’t paying much attention. Now, with the prices of goods and services moving up, they have new information, and the risk is that they begin to form new expectations.
“If it is the case that firms and households have increased inflation expectations, then realized inflation will follow suit,” Weber said. “They will bargain for higher wages.”
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