Nothing Is More Political Than Inflation

Towards the end of “Bad Optics,” I spoke briefly about the political ramifications of persistently high inflation.

When Joe Biden renominated Jerome Powell last month, some saw the decision as an implicit green light for the Fed to execute a hawkish pivot. There was plenty of boilerplate commentary about Powell being the “continuity” choice, but that was a red herring. Both Powell and Lael Brainard were continuity candidates. (It’s not exactly as if Brainard is an anti-establishment dark-horse.)

While some of Biden’s motivation for keeping Powell at the helm surely stemmed from a desire to avoid the appearance of politicizing monetary policy, the irony is that choosing Powell over Brainard may have been the more political move. If Biden’s choice was, in fact, a tacit nudge for the Fed to prioritize inflation, nothing could be more political. The figure (below, from BofA) underscores the point.

It may well be that Biden explicitly told Powell that fighting inflation is more important than hitting a moving target (inclusive labor market) and/or achieving a poorly-defined goal (maximum employment).

Odds are, stocks won’t totally crash in 2022 regardless of what the Fed does. By contrast, it’s certain that the GOP will use inflation against Democrats. Assuming American households ultimately care more about their grocery bill than whatever pittance they’ve managed to squirrel away in an index fund somewhere, fighting inflation at the possible expense of risk assets is the politically expedient thing to do.

The market is understandably perplexed by this — perhaps “irritated” is the better word. Powell came across as mercurial last week when, in his prepared remarks to the Senate, he seemed to suggest the Omicron scare is one more reason for policy to remain patient, only to turn around the very next day and bid “transitory” a decidedly unceremonious adieu.

“On the landscape of higher uncertainty, largely driven by exogenous shocks, where the probability of different outcomes is obscured and difficult to infer, the belief in the stability of the Fed’s reaction function and the predictability of its actions were the only things that investors could rely on,” Deutsche Bank’s Aleksandar Kocic wrote, in his latest. “We see the rate market’s forceful expression of discontent with the abrupt deviations from the script as a logical consequence of this state of affairs,” he added.

When it comes to Omicron, it’s important to note that should variant fears prove even a semblance of justified, there are two channels through which another COVID wave could exert more upward pressure on prices.

First, even in a relatively benign scenario, another wave could prolong supply chain disruptions. For example, Goldman on Saturday wrote that although the bank “continue[s] to expect an over-100bps decline in the contribution to core PCE inflation from auto prices alone between now and end-2022, a delay in the easing of supply constraints could keep core goods prices elevated well into the second half of 2022.”

Second, a more transmissible variant capable of evading vaccines could mean labor supply remains inadequate, especially to the extent fear of contracting the virus is the primary concern for many workers who’ve yet to come off the sidelines. JOLTS data for October is due next week and it’s unlikely the visual (below) will look much different once the latest numbers are incorporated.

“Delays in the easing of worker shortages could mean that the acute wage pressures from 2021Q2 and Q3 persist for longer than expected, with our most recent estimates suggesting that a 1pp acceleration in wage growth boosts core PCE price inflation by about 35bps,” Goldman wrote, in the same cited note.

If inflation is now the bigger risk to households and thereby the biggest political liability, then the inflationary risks associated with Omicron arguably mean the Biden administration would prefer a hawkish Fed.

The market is worried about a policy mistake in the traditional sense of the term. That’s reflected in the collapsing nominal curve (simple figure below).

It’s also possible that markets are dubious about the prospect of monetary policy being pushed and pulled by politics.

First, monetary policy was expected to complement fiscal stimulus in order to avert a deflationary spiral and prevent an outright depression. “Ironically, this very same policy must now distance itself from that mandate and (hastily) return to its traditional role of inflation vigilante facing an uncomfortable dilemma about the impact of its action on growth,” Deutsche’s Kocic went on to say, in a note dated December 3.

He went on to observe that “given the ample empirical evidence that in recent years politics has become more of a problem than a solution, it is not at all surprising that the market is expressing a high degree of skepticism regarding the effectiveness of this recent twist in monetary policy.”