We have now heard from the Fed and J. Powell.
Overall, there were no big surprises. The only relevant change was in the statement (the change in the language is not surprising given the evidence of broadening / more persistent price pressures we have circulated recently).
We found Powell’s word extremely well balanced. All the doors are open going forward and the Fed will remain data dependent. Given the high uncertainty, we think the Fed approach remains correct. Most are focusing on inflation being too high and the Fed being behind the curve; however, it is also possible that inflation will come down significantly in 2022, and in this scenario raising rates prematurely would be a policy mistake. For the time being, the Fed will remain flexible, an approach that can buy some optionality for mid-’22.
In the statement, the Fed went from “inflation is elevated, largely reflecting transitory factors” to “inflation is elevated, largely reflecting factors that are expected to be transitory”.
Comment: the Fed (staff) has been upwardly surprised by the incoming data and by the persistency of the supply bottlenecks. At this point, as we discussed in recent weeks/months, the Fed (staff) is guessing that they will be solved relatively soon. The change of language is in line with the known unknowns.
In his prepared speech, Powell said that “it remains the case that the drivers of higher inflation have been predominantly connected to the dislocation caused by the pandemic. Specifically, the effects on supply and demand from the shutdowns, the uneven reopening, and the on-going effect of the virus effect. […] Our tools cannot ease the supply constraints. […] We continue to believe that our dynamic economy will adjust to the supply and demand imbalances and that as it does, inflation will decline to much closer 2 percent target.
Comment: Powell’s words continue to reflect the Fed staff framework. In that framework, the fundamentals of inflation for 2021 are well below the currently elevated readings (and a bit below target). The staff therefore continues to believe that inflation has been pushed up by (transitory) supply bottlenecks and (transitorily) strong demand.
Question: How do you see wage dynamics?
In his reply, Powell stressed that wages have been moving up strongly. However, in real terms, they have been much more stable than in nominal terms. He also added that “If wages had to be raising persistently above inflation and productivity, it would put pressure on firms to raise prices. We don’t have evidence of a wage-price spiral. We don’t see troubling increasing in wages at this time.”
Comment: even in this case, Powell’s words reflect the Fed staff framework of wage dynamics. According to my best guess of the Fed staff wage decomposition, wage growth in 2021 is above the fundamentals (underlying inflation, trend productivity, and slack) partially due to aggregation biases in the data and partially due to a tighter labor market than suggested by the unemployment gap only. Not only, but as we remarked in various circumstances, the current level of wage growth is not robust enough to result in a spiral. The wage-price spiral can indeed occur down the line but it would need a significantly higher wage growth.
Question: Do you think your message of transitory inflation is reaching families hit by higher prices?
Powell stressed two things: 1) The Fed has a dual mandate; the current level of inflation is not consistent with price stability but the labor market is not at full employment and 2) the word “transitory” means different things to different people (for some, it means “short-lived”, while for the Fed it means it will not leave a permanent print on inflation rate).
Comment: About 1) we think Powell is right stressing the labor market condition, especially because while inflation is certainly high, the real disposable personal income has not been hit by the spike in inflation (indeed, it is now on its pre-Covid trend after running significantly above it during the pandemic). In other words, we don’t think the question was fully justified by the data because households have not lost purchasing power despite higher prices (and you can see it in the spending data..). About 2) the notion of inflation being “transitory” has to do with the Fed staff decomposition (as discussed in private meetings several times). Powell’s words are a confirmation that he has the idea of underlying inflation (pi*) in the back of his mind. Indeed, in that framework, a shock that does not leave a permanent print on inflation (that is, a permanent print on pi*) is transitory by definition (with the usual caveat that transitory does not rule out “persistency”, a notion that is traditionally more linked to the idea of “economic cycle” / “slack”). One way of (maybe) simplifying the discussion would be to start talking about “trend inflation” (which is one of the 3 pillars to estimate pi*), although even this approach would probably create communication challenges for the Fed.
Question: are the tests for inflation met?
Powell remarked that this is not a question the FOMC can or want to discuss right now. Rather, it is something that the committee will discuss once full employment will be met. He also said that it is possible that the inflation “tests” (that is, the conditions on the inflation front to hike) will be met once the economy will be at full employment.
Comment: We think many people are focusing exclusively on inflation right now. As a reminder, the Fed has a dual mandate and the labor market leg is not necessarily in a good shape at the moment. Also, under the new framework, the FOMC has pre-committed to hike only after reaching both, full employment and AIT (that is, after raising pi* to 2 percent). In other words, the bar for hiking is (at least in theory) much, much higher than the one for tapering.