FOMC: more aggressive than expected.
“Committee acutely aware of the need to return the economy to price stability”
The outcome of March 2022 FOMC was a bit more hawkish than we expected.
Powell sent a clear signal: inflation is too high and patience is over.
Dots plot
The newly released dot plots are more hawkish than implied by the Fed staff (2021) rule. According to our Pre March 2022 FOMC Meeting, the Fed staff (2021) rule implied the FF rates at 1.5% at the end of 2022, 2.2% in 2023, and 2.7% in 2024. Therefore, the rule predicted the terminal part correctly but underestimated the front part. The miss is due to two factors. First, the prediction was based on a lower forecast in 2022 for core PCE price inflation (assumed at 3.2%). However, even conditional on a 4.1% forecast in 2022 (and 2.6% in 2023), the Fed staff (2021) rule would still underestimate (by a touch) the path of the FF rates. This happens because of the second factor: the inertial coefficient. In the Fed staff (2021) rule the inertial coefficient is set at 0.94. However, what the new dots plot seems to suggest is that the FOMC is now less inertial than in the past (last cycle). Lowering (by a touch to 0.93) the autoregressive coefficient of the rule brings it in line with the new median. The figure below shows the new path of the FF rates from the dots plot (black dashed line) and the Fed staff (2021) rule (with lower inertial). The bottom line is that the FOMC seems to be more reactive to changing conditions.
Statement
Regarding the statement, several changes were implemented. In general, the statement now stresses more that pressures are broad-based. Also, the statement acknowledges that the implications of the on-going war in Ukraine remain uncertain but in the near-term is likely to create additional upward pressure.
Comment: needless to say, we agree with the implemented changes and we do agree about the implications for inflation of the Ukrainian war.
Q&As
Question: When do you expect inflation to come down?
In his answer Powell reminded that before the on-going war in Ukraine, the expectation was that inflation would peak some time in the first quarter (maybe in the end of the first quarter) of this year, remain around that level for some time and start declining in the second half of the year. However, Chair Powell stressed that we have now seen additional upward pressure on consumer prices coming from commodity prices, renewed supply chain issues, and shipping costs. These additional factors are expected to push further out the moment in which inflation is expected to moderate, although Powell seems convinced that some moderation will materialize in H2.
Comment: upward revision to inflation forecasts have been the norm since the beginning of the pandemic. At this point, forecasting a significant slowdown in the second half of the year is more a hope than a real forecast. It can happen but it requires the level of durable goods to drop (as discussed in the past), which might or not happen depending on whether supply chain issues will be solved in time. Given that most forecasters (including the Fed) have underestimated the issue so far, and given the evidence of the incoming data, we belong to the camp of “inflation will continue to remain robust, unless otherwise proven”. Should the evidence change, we will change our mind. But the evidence continues to point to strong readings.
Powell received 3 separate questions regarding the Fed strategy to reduce inflation. The questions can be expressed as follows: how can inflation moderate if the FF rates remain below neutral in 2022? How can inflation moderate without raising unemployment? Are we in a wage-price spiral?
First of all, Powell reminded that some factors behind the forecasted moderation in inflation are factors unrelated to monetary policy (such as base effects, supply-chain issues, etc..). However, in his answers Powell talked about the state of the labor market stressing the current behavior of wage inflation. In particular, the Chair seems to think that the labor market is so tight (“tight to an unhealthy level”) that cannot be excluded that wage growth is putting some upward pressure on consumers prices. In this regard, Powell also stressed that part of the strategy is to bring demand in line with supply, not only on the goods market but also on the labor market (therefore giving time to workers to come back and wage growth to moderate).
About inflation moderating, Powell said: “Part of inflation coming down has clearly to do with factors other than our policy, and those would include potentially supply-chain getting a little bit better, […] base effects” “Really what we are looking for is month-by-month inflation coming down” “it’s really… it’s all the things we’ve been talking about that really haven’t helped much, including the shift away from goods and back to services, including supply chains getting better, including labor force participation… all those things have been sticky and not happening” “monetary policy starts to bite on inflation with a lag of course and so you would see that more in 2023 and 2024”.
About the connection between price inflation and the unemployment Powell said: “In the economy we had before the pandemic, the connection between inflation and unemployment was not very tight. Clearly this is an expectation that the idea that wage increases, which are running above the level that would be consistent with 2% inflation, will move back down to levels which are still very attractive, full employment kind of wages, but not to a point where they are pushing up inflation anymore.”
About wage increases Powell said: “What we have now if you look at these wages increases that we have, we are blessed to have a range of measures of wages that all measure different things, but right now they are all showing the same thing which is that the increases, not the levels, but the increases are running at levels that are well above what would be consistent with 2% inflation, our goal over time. We don’t know how persistent that phenomenon would be, it’s very hard to say”.
Comment: We do agree with Chair Powell that some factors behind the currently elevated inflation (and its possible moderation going forward) are well beyond the power of monetary policy. We notice that Powell (and in our view also the Fed staff) has come to agree that wage growth is now way above the fundamentals (underlying inflation, trend productivity, slack – see our Pre FOMC meeting package). However, we are less optimistic than Chair Powell about labor market tightness and its implications for wage growth going forward. We continue to think that labor demand will remain above well above supply this year and consequently wage growth will remain above the fundamentals (although less than last year). Technically, it is still hard to argue that the US economy is in a wage-price spiral because long-term inflation expectations remain stable (anchored). However, observed wage growth (5% on average across measures) is much stronger than productivity (plus trend inflation). Therefore, unless nominal wage growth will drop to around 3%, we will not be able to dismiss the hypothesis of an on-going spiral.
Finally, Powell was asked whether he was concerned about services inflation, given that it tends to be more cyclical and more persistent.
Powell answered that: “it’s something we are watching report by report, we noticed in the last meeting, and it’s part of the overall picture. We have expected services inflation to move back to where it was” […] “in the case of some services, prices are still getting back up to where they were before the crisis. In other cases, it is clear inflation it has spread more broadly. That is concerning. Meanwhile, we have seen progresses on the goods side. In this latest report, it was confined to vehicles which is admittedly a large category.”
Comment: We partially agree with Powell: the acceleration in services inflation is concerning. It can be offset by goods inflation but only if the level of durable prices will fall. However, we remain skeptical that the deceleration in goods inflation will offset the on-going acceleration of services inflation.