Fed Minutes Describe Combustible Inflation Setup

The word “restrictive” showed up just once in the May FOMC minutes, but allusions to front-loading rate hikes and getting policy to neutral sooner rather than later were a fixture.

Participants “noted that a restrictive stance of policy may well become appropriate depending on the evolving economic outlook and the risks to the outlook,” the minutes said. “Many participants judged that expediting the removal of policy accommodation would leave the Committee well positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.”

There was little ambiguity on the likely outcome of the next two meetings. “Most” officials said 50bps increases will “likely be appropriate.” Markets have priced that as a near certainty, even as a weak run of data and comments from Raphael Bostic prompted traders to reassess the balance of risks for the September meeting.

Read more: Fed ‘Pause’ Narrative May Be Wildly Overblown

There was a nod to “risk-management considerations” in the May minutes, which could be interpreted however you like. If you’re hoping the Fed blinks, you could read it as lip service to the possibility that a loss of economic momentum may warrant a less aggressive policy bent as summer melts into autumn. It could also mean inflation realities might require an even more forceful response.

The following paragraph, excerpted from the account of the meeting, is somewhat difficult to square with the Committee’s measured, 50bps cadence:

Inflation pressures were evident in a broad array of goods and services. Various participants remarked on the hardship caused by elevated inflation and heightened inflation uncertainty—including by eroding American families’ real incomes and wealth and by making it more difficult for businesses to make production and investment plans. They also pointed out that high inflation could impede the achievement of maximum employment on a sustained basis. Participants noted that developments associated with Russia’s invasion of Ukraine, including surges in energy and commodity prices, were adding to near-term inflation pressures. In addition, COVID-related lockdowns in China were likely to disrupt global supply chains, potentially adding further upward pressure on the prices paid by US businesses and consumers. Most participants indicated that their business contacts had continued to report that substantial increases in wages and input prices were being passed through into higher prices to their customers. A few participants added that some of their contacts were starting to report that higher prices were hurting sales.

With the obligatory admission that the Fed can’t control the war or Beijing’s COVID policies, and at the risk of echoing Bill Ackman’s alarmist assessment, that passage appears to suggest the problem is as acute as it is pervasive. It needs a serious response. At the least, it argues for an RBNZ-style commitment to reaching neutral as soon as possible.

Of course, the minutes were full of references to the necessity of moving “expeditiously,” but the Fed is playing from behind. RBNZ started hiking in October, for example, and would’ve hiked in August were it not for a snap lockdown associated with the Delta wave. As of Wednesday’s move, New Zealand’s policy rate is already at the lower-end of the central bank’s estimate of neutral. The Fed is nowhere near its own such estimates.

The minutes mentioned the ratio of job openings to Americans officially counted as unemployed. The Fed is implicitly (and almost explicitly) relying on the idea that those openings would be superfluous if demand slows, and therefore could be viewed as “free” to the extent eliminating them wouldn’t entail someone losing a job.

“Several participants raised the possibility that, in light of the exceptionally high ratio of vacancies to job searchers, a moderation in labor demand might serve to reduce vacancies and wage pressures without having significant effects on the unemployment rate,” the minutes said.

Powell repeatedly referenced the figure (above) during the May press conference, and several banks have made similar remarks.

Read more: ‘Necessary’ Slowdown Doesn’t Mean Massive Job Losses, Goldman Says

Fed officials generally insist they see no evidence of a wage-price spiral. Almost no one agrees. Such evidence is abundant. And, with wage growth still undershooting inflation by a large margin, workers will likely continue to press for higher pay, which will in turn prompt employers to raise prices in an effort to protect margins.

The minutes also noted that the current pace of nominal wage growth, insufficient though it may be to keep real wage growth in positive territory, is “run[ning] above levels consistent with 2% inflation over time.” Once again, “some” participants flagged the risk that longer-term inflation expectations “could become unanchored,” at which point “the task of returning inflation to 2% would be more difficult.”

All in all, there were no surprises in the minutes. The Fed is intent on getting rates to neutral, and will hike 50bps in June and July absent an outright meltdown in financial markets or an economic deceleration far more pronounced than what markets watched unfold in May.

The irony, if Ackman and those who’ve expressed similar sentiments are correct, is that not moving more aggressively risks the very kind of equity meltdown that could paradoxically compel a pivot, setting the stage for a nightmarish feedback loop wherein the Fed inadvertently makes sentiment worse by giving investors a dovish nod when what the market really wants is an unequivocal show of force in the face of highly corrosive price pressures.

In any case, not everyone agrees with that line of reasoning. But everyone does agree that the situation is at least a semblance of urgent.

Finally, I’d note that the minutes spoke to the issues discussed in “Treasury Market Risks ‘Vicious Liquidity Feedback Loop’ as well as to hidden risks associated with turmoil in commodities. “Several participants… noted that the tightening of monetary policy could interact with vulnerabilities related to the liquidity of markets for Treasury securities and to the private sector’s intermediation capacity,” the Fed said, adding that “the trading and risk-management practices of some key participants in commodities markets [are] not fully visible to regulatory authorities.”