The Fed minutes of the May 2022 FOMC revealed hawkish calls of the Fed staff.
Please, see below for details and discussion.
The Fed Staff forecast
According to the minutes:
“The staff’s projection for PCE price inflation was revised up slightly in the second half of 2022 and in 2023 in response to the slow resolution of supply constraints seen over the first part of 2022, a higher projected path for import prices, and a judgment that wage increases would put more upward pressure on services prices than previously assumed. All told, total PCE price inflation was expected to be 4.3 percent in 2022. PCE price inflation was then expected to step down to 2.5 percent in 2023 and to 2.1 percent in 2024 as supply–demand imbalances in the economy were reduced by slowing aggregate demand and an anticipated easing of supply constraints.”
Discussion
The figure and table below show the Fed staff forecast for core PCE price inflation as well as a comparison with past Tealbooks (as always, the Fed staff forecast is inferred from the FOMC minutes).
In our view, at the time of the May Tealbook the Fed staff expected core PCE price inflation at 4.0 percent in 2022, 2.5 percent in 2023 and 2.1 percent in 2023. In our view, compared to the March Tealbook, the Fed staff has revised up its forecast by about 3 tenths in 2022 and 2 tenths in 2024.
The core PCE price inflation decomposition: Figure and Table
We note four important points from the minutes.
First, the Fed staff has revised up its forecast in reaction to a higher path of core import prices. This is not surprising: according to our pre May 2022 FOMC meeting package, the incoming data were -on net- stronger than expected by the Fed staff (and not softer as argued by many), as the soft March CPI print was more than offset by strong core import prices data (which are currently running in double digits 3m/3m a.r.).
Second, the staff has (finally) admitted that supply constraints might not resolve as quickly as anticipated and might continue in the second half of the year. We agree with the (revised) Fed staff view: there is little evidence that supply chain issues can be fixed any time soon. Rather, the data continue to show elevated stress which should put some upper pressure on prices going forward.
Third, the 2.5 percent forecast in 2023 reveals, in our view, that the staff is assuming a level of underlying inflation (pi*) of (about) 2.3 percent in 2022 and 2.2 percent in 2023 (both revised up 1 tenth compared to the March FOMC). Needless to say, in our view this is a very hawkish call from the staff. The message sent to the FOMC is clear: the Fed is playing with fire and the evolution of pi* must be controlled.
Finally, for the first time the Fed staff has admitted and judgmentally folded into the forecast that wages are already putting upward pressure on consumers prices. (unsurprisingly from our point of view given the evidence from the ECI wage decomposition, as previously discussed). In our view, this is another hawkish call of the Fed staff: a (small) spiral cannot be excluded anymore and must be stopped. (please note that this is in contrast with the traditional point of view of the staff which tended to estimate zero passthrough from wage inflation to consumers’ price inflation – see Peneva and Rudd (2015)).
To sum up
The Fed staff forecast is constructed conditional on the assumed path of the FF rate (which in our view is now following the Fed staff Taylor rule (2021)).
Today’s minutes are very important because they reveal that, conditional on the path of the FF rate, the Fed staff expects core PCE price inflation to remain elevated in 2023 and barely return to target in 2024. Not only, but underlying inflation seems to be dangerously trending higher and a wage price spiral might already be in place.
Translated: the FOMC can decide to take the risk, accept a higher inflation in 2022 and 2023 and (maybe) land softly in 2024. But all the risks are to the upside. Therefore, in our view, the Fed staff forecast is calling for a more aggressive monetary policy. At this point, there are not many other ways to reduce the risks around the forecast.