The Federal Reserve’s recent aggressive rate signal has created uncertainty in markets and some investors wonder whether the central bank is paddling back on its promise to tolerate higher average inflation. But Talib Sheikh, Mark Richards and Matt Morgan argue that the Fed is effectively creating wiggle room to act if inflation proves to be sticky.
The Federal Reserve’s (Fed) June monetary policy review caught investors by surprise. The realisation that the central bank could raise interest rates sooner than earlier expected jolted the markets.
In the run up to the meeting, Fed officials repeatedly insisted that they expected the inflation indicators we were seeing would be “transitory”. Another reason for the turbulence is that the market had settled into a sense of comfort after the Flexible Average Inflation Targeting or “FAIT” framework was unveiled last year.
We’ve said many times the framework review heralded a significant shift in monetary policy for the Federal Reserve (see here and here for more). The shift to FAIT would mean that after 40 years of taking the fight to inflation, the Fed would be more lenient, letting the economy run hotter and only reacting when inflation was higher and forward inflation expectations were embedded at a level consistent with the Fed’s mandate. That view seemed to be confirmed as we moved well into this year, with the Fed’s inflation statements also calming markets.
A big shift
But the latest dot plot showed a majority of Fed officials expect two rate increases by the end of 2023, a big shift from the March review. The key change was that Fed had previously promised to move based on inflation progress, seeing the whites of inflation’s eyes before moving, tolerating above target inflation for periods in order to achieve an average target over the medium term.
At face value the Fed appears to have changed its projected rate path in reaction to its perception of upside risks to its inflation forecasts, without a commensurate hike in growth expectations. Was this a change of approach?
We don’t think so. What has changed is not the framework, it’s the Fed’s view of inflation risks. The committee was unanimous that uncertainty around inflation is high, and we’d agree: supply bottlenecks are making data difficult to interpret. A majority of the committee think the balance of inflation risks is to the upside.
Typically, we ignore the dots and non-core speakers, but FAIT architect, Vice Chair Clarida, seems to be one of the members advocating two hikes in 2023.
The second reason we don’t think this is a change to policy is that not much has changed: the Fed has modestly increased its inflation expectations while noting a very high degree of uncertainty, and modestly increased the projected pace of rate rises. The expected pace of rate rises remains very slow and is conditional on forecasts coming to fruition. If as many expect inflation is transitory, there is plenty of room for the Fed to turn dovish later this year. So, by increasing uncertainty now they buy themselves two-sided optionality: they can have their cake and eat it.
Why the change
Analysing what Chair Powell said last Friday and the comments from him and some of his colleagues since the meeting, we’d summarise the Fed‘s thinking as follows:
Inflation versus employment
We think the Fed hoped that reopening would cause the US to return to full employment rapidly, which would be followed by gently rising inflation. We’ve seen the opposite: inflation has been rising steadily, but job gains have undershot expectations. At the meeting Powell cited supply bottlenecks for upside inflation risks. The Fed still thinks inflation is transitory but see some risk that it hangs around for a little longer than expected, and they want to manage that risk.
Managing the “risk” of inflation upside surprise is key here: the Fed made no change to its 2023 inflation projections, but tilted the balance of risks to its forecast to the upside. This seems to be the motivation behind the expected further path of interest rates. However, this reintroduces the concept of “risk management”: placating fear that the Fed may have been too dovish and allow the economy to run too hot, necessitating having to hike rates aggressively later on. The Fed has in its view seen a modest upside risk to inflation and made a modest change to its forward guidance to manage that risk.
Several committee members have noted that fiscal policy has also surprised to the upside so far this year. Furlough payments are continuing through the summer, and cheques of up to $500 a month in child credits are hitting family bank accounts from this month onwards. The administration continues to push to agree an infrastructure plan which is likely to lead to more spending in the next 18 months. This is clearly a part of Fed thinking: fiscal policy is doing more of the heavy lifting and that can continue.
Given all these factors, here is our assessment. The market has probably overreacted to a modest repricing of inflation risk and a tweak to forward guidance by the central bank. Policy remains accommodative and supportive for risk assets.
What worries us? The possibility that the Fed has decided it’s been successful in generating modestly higher inflation prematurely, that this short period of above average inflation is enough to meet the goals of the new FAIT framework. We think inflation broadly remains transitory and we haven’t yet seen a sustained shift in inflation expectations or wage growth.
The difficulty for the market here is the “F” in “FAIT” – “flexible average inflation targeting”. The Fed has consistently resisted calibrating what constitutes a period of above average inflation and over how long that average would be calculated. Not knowing the answer to this makes the future much less certain. We are alive to the risk that higher nominal growth or inflation will bring tapering forward, or increase the path of rate rises.