Please, find below today’s FOMC and Powell’s main points on inflation and related areas followed by our comments. Overall, in our view a smooth FOMC and press conference. All the options are (finally) open for 2022 and the Fed appears now well positioned to address any scenario. Nevertheless, few points in Powell’s words need to be clarified.
Statement
In the statement, the FOMC wrote: “With inflation having exceeded 2 percent for some time, the Committee expects it will be appropriate to maintain this target range until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.”
Comment: the statement confirms that the FOMC seems to think there is enough evidence (trend inflation and long-term inflation expectations) to conclude that pi* has moved up to target. As discussed in private meetings, the Fed staff will need more time to conclude that pi* has risen but given the risks around the inflation outlook the FOMC cannot wait. Needless to say, this does not imply that the behavior of future actual inflation will be irrelevant. Quite the opposite, most FOMC members will continue to rely on the staff framework, including the assessment of underlying inflation. The behavior of future actual inflation will need to confirm the FOMC view.
Dots plot
About the new dots plot, we notice that the Fed staff (2021) Taylor rule continues to fit the (median) dots perfectly. The path of the Fed staff (2021) Taylor rule conditional on the new SEP forecasts for core PCE price inflation and the unemployment gap is nearly identical to the one we have circulated in our “Pre FOMC-Meeting Package” and fits the new median dot perfectly. Please, find below the updated chart.
Prepared remarks
Powell: “Bottlenecks and supply constraints have been greater and longer-lasting than anticipated. Inflation will continue to rise beyond our 2% target well into the following year. Price increases are now broader. By the end of 2022 I expect inflation to be closer to 2%”.
Comment: Powell appears to be on board with reality now and well positioned to act in 2022 if inflation will persist more than expected. This is the first meeting at which he sounds in line with the reality of the incoming data.
Q&As
Question: What triggered your turn on inflation?
Powell. “Back in spring, inflation was run by a limited number of items. Then, we had months of declining inflation. In September, it became clear that it was more widespread and more persistent. Therefore, we decided to accelerate tapering. […] I decided to speed up tapering because of greater inflation and considerably faster job progress. […] We got the ECI very high just before November meeting and after that we got a strong labor market report and another strong CPI report”.
Comment: unsurprisingly, Powell admitted that the Fed staff and the FOMC have been surprised by the strength of the incoming data. This is no surprise to us because we have been signaling significant near-term upward risks around the Fed staff forecast (and we still see them, at least for another 2-3 months). The real news is that Powell mentioned the ECI. Indeed, we are well aware of the importance of monitoring wage data, including the ECI decomposition (see our “Pre FOMC-Meeting Package”) to assess the general equilibrium of the economy.
Question. How do you understand that wage growth is not part of the current inflation?
Powell. “Wages are not a big part of the inflation you see now. When you look forward, if real wages were well above productivity growth, it would put significant upward pressure on prices.”
Comment: two points on this. First, the level of wage growth (see our “Common Wage Model”) is comparable to the pre-Great Recession period so it is still hard to think that wage growth is putting upward pressure on consumers’ prices (on this point, see Peneva and Rudd (2015)). Second, in our view Powell has in mind the Fed staff ECI decomposition (which we report here below). In this framework, ECI growth is driven by underlying inflation, structural productivity, and slack. Anything else (“other factors”) is seen as a transitory residual (that is, a factor not related to the fundamentals). In 2021, ECI growth is running above the fundamentals (which explains why he mentioned the high ECI reading before the Nov FOMC). However, the 2021 reading continues to be distorted by within sector shifts in aggregate hours and employment. For this reason, it will be crucial to monitor ECI (and the ECI decomposition) in 2022. ECI growth in 2022 is expected to decrease to 2¾ percent and any reading above 3½ percent might make the Chair nervous.
ECI wage growth (Q4/Q4) decomposition
Question. How do you know you are at maximum employment?
Powell “The inflation we’ve seen is not at all what we were looking for in our framework. […] This inflation has nothing to do with tightness in the labor market. […] With inflation so much above target, we can’t afford to wait too long to reach full employment.”
Comment. This has been the most problematic question/answer in our opinion. Unfortunately, nobody asked Powell the most important question, that is “what is your assessment of the level of underlying inflation?”. What Powell meant when he said “this is not the inflation we were looking for in our framework” has to do with the “decomposition” (shown below). What the Fed was aiming was to reach a level of core PCE price inflation moderately above 2 percent as a result of underlying gradually reaching 2 percent and a tight labor market putting additional moderate upward pressure. Instead, the Fed has to deal with a huge yellow bar (“other factors”) in 2021 with some uncertainty about the level of pi*.
Core PCE price inflation (Q4/Q4) decomposition
Question. What makes you think that inflation will drop significantly in 2022?
Powell: “There’s a serious risk that inflation may become more persistent. The likelihood of higher inflation becoming entrenched has grown.” […] “We cannot act as if we knew that it will be lower in 2022.”
Comment: Powell has bought optionality (and rightly so in our view) for 2022. Indeed, as we have signaled in our updates, the likelihood of inflation remaining moderately above target at the end of 2022 has increased. Powell has acknowledged it.
Question: Is the Fed behind the curve on controlling inflation?
Powell: “”We’ve been calling out the fact those are becoming larger and more persistent, and now we’re ending our taper by March, in two meetings. And we will be in a position to raise interest rates when that’s appropriate, and we will.”
Comment: again, Powell has bought optionality for 2022.
Question. Do you think you can hike before finishing tapering?
Powell: “It’s not suitable to lift rates while taper is ongoing. […] We have not taken a stance on whether we should pause between the conclusion of the taper and the first rate hike. […] I don’t see a long delay between the taper process and the rate hike.”.
Comment: several FOMC members had already signaled their preference to finish tapering before hiking so Powell’s words are unsurprising. As for hiking, the Fed will remain data dependent. At the moment, the first option to hike is probably the June 2022 meeting but the incoming data will remain crucial.