It’s official. Inflation isn’t “transitory” anymore.
Not that American consumers needed confirmation. And even if they did, everyday people don’t look to FOMC statements for guidance, “forward” or otherwise.
But for investors and traders, the December Fed statement was a watershed moment of sorts.
Two weeks after telling US lawmakers that the “T word” was, like so many former members of the US labor force, headed for early retirement, the Fed dropped the “transitory” characterization of price pressures. Instead, the December statement said simply: “Supply and demand imbalances related to the pandemic and the reopening of the economy have continued to contribute to elevated levels of inflation.”
An overhaul of the inflation language was expected, of course. As was a formal unveil of an accelerated taper pace. Asset purchases will be pared by $30 billion per month beginning in January (figure below). The Fed cited “inflation developments and the further improvement in the labor market.”
Theoretically, the Fed could start hiking rates once the taper is complete. In other words, liftoff will be a “live” debate in relatively short order, although that comes with the usual caveats and skepticism about the market’s capacity and/or willingness to countenance the very same hawkishness STIRs are pricing.
The fresh dots reflect three hikes in 2022, three in 2023 and two in 2024. So, the Committee is effectively pulling one hike forward. The new projections revealed the expected upward revision to inflation forecasts. The projections for headline and core PCE in 2022 were revised to 2.6% and 2.7% from 2.2% and 2.3% in September. For 2023, they’re both 2.3%.
As for growth and unemployment, the economy will expand 4% next year and 2.2% the year after, while the unemployment rate is seen falling to 3.5% in 2022 versus 3.8% three months ago. In September, the 2022 and 2023 growth projections were 3.8% and 2.5%. This year’s projections for PCE and GDP were revised to 5.3% from 4.2% and 5.5% from 5.9%.
With allowances for a projected better growth outcome in 2022, the revisions suggest higher inflation, slowing growth and full employment. You can choose your own adjective.
The nominal curve came into the December meeting screaming about a policy error and surveys suggest investors now see a hawkish Fed as the biggest risk. Long bond yields are the lowest since January and market-based measures of inflation expectations have collapsed from local highs (figure below).
In the December edition of BofA’s Global Fund Manager Survey, just 15% of respondents identified a COVID-19 resurgence as the top tail risk. By contrast, hawkish central banks garnered 42%, while inflation claimed 22%.
In simple terms, the concern is that, having fallen behind, the Fed will be overzealous in restoring its inflation-fighting credentials. Many worry that the Committee’s newfound zeal will translate into market volatility or, at worst, dead end in an inverted curve and a recession.
They have little choice but to pivot, though. Calls for the Fed to “do something” about inflation crescendoed over the past two months, as headline CPI accelerated at the swiftest 12-month pace in four decades. More worrisome is the broadening out of underlying price pressures (figure below) and the persistence of pipeline inflation, both of which suggest no synonym of “transitory” is appropriate when it comes to assessing the temporal scope of the problem.
At the same time, the Fed is under political pressure, just not the overt variety Jerome Powell was subjected to during Donald Trump’s presidency. Joe Biden’s poll numbers have declined with rising prices.
Inflation isn’t The White House’s only problem, but it’s a problem. In addition to giving Republicans a go-to talking point ahead of the midterms, scorching-hot CPI prints are a factor in Joe Manchin’s recalcitrance vis-à-vis Biden’s social spending plan.
The Fed’s capacity to help is limited. Rate hikes won’t solve supply chain problems, but the cessation of MBS purchases could help arrest the inexorable surge in home prices. And nods to tighter policy might eventually mitigate consumers’ inflation expectations, although that assumes the average American understands the mechanics, a questionable proposition in an era where attention spans are measured in seconds, not minutes, let alone hours.
Not the only (but certainly a) tail risk now is that inflation falls faster and more than economists and inflation hawks are expecting. I would want to be long a lot of things in that scenario, but who knows? I guess the only sure bet is that volatility is likely to be with us for a while.