Inflation Expectations and Monetary Policy
The Fed's Current Conundrum
Jay Powell and his colleagues on the Fed are wrestling with some particularly difficult questions of data interpretation and the implications for monetary policy. As previously reported, the May CPI report reflected a continuation of rapidly rising prices in some sectors of the economy. The May report indicated a headline inflation rate of 5% for the last 12-months, or 3.8% excluding the volatile food and energy components. But the May numbers were heavily influenced by the prior period comparisons (when large parts of the economy were still in shut-down mode) and by exceptionally large price changes in a few specific sectors of the economy impacted by significant supply and demand “bottlenecks” (eg used cars and trucks, and airline fares), which the Fed believes may be “transitory”. For a better understanding of the composition of the May inflation data, I encourage you to read (or reread) the BLS report, found here: https://www.bls.gov/news.release/pdf/cpi.pdf
The Fed is also monitoring anecdotal and empirical evidence of rising inflation expectations, which may at some point become significant enough to change the Fed’s policy calculus of when to begin raising rates and by how much. You will recall from a prior post that one capital markets measure the Fed is watching is the 5-year forward breakeven inflation rate—the difference in nominal and real yields on 5-year UST notes and TIPS—which has increased from 0.3% in March 2020 to about 2.7% prior to the May CPI report, and which currently stands at around 2.5%. While this data clearly indicates a significant rise in inflation expectations over the past 15 months or so, this is off a very low base (during the peak Covid panic period) and at 2.5% is still well within the Fed’s near-term comfort zone. You can find the FRED data here: https://fred.stlouisfed.org/series/T5YIE
Even if the Fed does not believe that any of this amounts to the beginning of 1970s level inflation threats (as discussed in my recent post), the Fed still has reason to be concerned. Once inflation expectations become widely held among producers and consumers, rising prices tend to become a self-fulfilling prophecy and become harder for the Fed to counteract. Under more normal circumstances, the Fed might act to nip this sort of incipient inflation in the bud if they believed that failure to do so would risk inflation rising too far above its policy target for too long a period of time. Given current circumstances, however, the Fed has indicated that it welcomes a rise in inflation to levels somewhat above its 2% target for some period of time, in order to compensate for the long period of below-target inflation during the Covid-related shut downs.
It is worth reminding ourselves here that price stability is not the Fed’s only economic mandate. By law the Fed is also charged with maintaining full employment. Whether we view these as two competing mandates or one internally consistent mandate (on the theory that stable prices are conducive to maximizing employment), the Fed pays close attention to both inflation and employment. One reason the Fed may be reluctant to take aggressive early action on the inflation front is that a premature or too aggressive tightening of monetary policy runs the risk of derailing recent increases in economic growth and declines in the unemployment rate, which while much reduced from its recent peak is still above pre-pandemic levels. Managing the tradeoffs between inflation and unemployment is a challenging task for the Fed even in “normal” times, but it is even more difficult today.
One reason the Fed’s current task is so difficult is because there is a lot we simply do not understand about the economic impact of the pandemic (and the related governmental policy responses) on the real economy and its responsiveness to future changes in monetary policy. We have never lived through a period quite like this one and neither has the Fed. So it is very unclear how much confidence one can or should put in historical data and past experience. How much of the recent price increases reflected in the May data is in fact “transitory” (as the Fed believes) and how soon will the identified supply and demand bottlenecks clear? When this happens, will prices revert to pre-pandemic levels or to some new higher levels of “normal”? What is really going on in the labor market, with new patterns of remote work and the widely reported reluctance of many workers to return to their old jobs? What has been the impact of Covid (and the related policy responses) on the “natural” rate of unemployment, so often cited by the Fed? How should the Fed weigh the possibly asymmetric risks to the economy from alternate courses of action? If the Fed is going to err, in which direction should it do so?
I am not an economist and you should not view me as an expert on these questions. But these are difficult questions which the Fed is wrestling with in real time, and the decisions the Fed makes will impact us all, for better or worse (or some of each). So by all means let’s continue to follow this story and make sure we understand what is going on and why. This policy debate is too important to be left to the experts.
For a better explanation of what’s going on in the mind of the Fed, read this article from Greg Ip, chief economics commentator for the WSJ: https://www.wsj.com/articles/behind-fed-confidence-on-inflation-some-anxiety-creeps-in-11623883639?mod=hp_major_pos2#cxrecs_s
Or if you would rather hear from Jay Powell directly, watch here: https://m.wsj.net/video/20210616/061621fedreserveinflation/hls/manifest-hd-wifi.m3u8