– Wage-Price Trends Have Dramatically Changed the Fed’s Policy Calculus
By Steven K. Beckner
(MaceNews) – Who would have imagined just a short time ago that the Federal Reserve would not only be accelerating reductions of asset purchases before year’s end, but signaling an intention to raise short-term interest rates sooner and more rapidly than earlier anticipated?
Well, here we are, because basically the Fed has been “mugged by reality,” to borrow a phrase.
At the upcoming Dec. 14-15 meeting of the Fed’s rate-setting Federal Open Market Committee, it seems highly likely that we will see an acceleration of monetary firming – or at least signals that it is coming unless troubling inflation trends change.
Until very recently, Fed Chairman Jerome Powell, not to mention predecessor (and current Treasury Secretary) Janet Yellen, was calling inflation “transitory.” The same language was incorporated in the policy statements of the FOMC up to an including the early November one.
Some Fed policymakers even continued to worry that inflation might fall back below the FOMC’s average 2% target.
Not until its Nov. 2-3 meeting did the FOMC get around to deciding that “sufficient further progress” had been made toward its “maximum employment” and inflation goals to start “tapering” the Fed’s $120 billion monthly asset purchases. It was decided that bond buying would be reduced by $15 billion per month – $10 billion of Treasury securities and $5 billion of agency mortgage backed securities.
Now, suddenly, Powell and many of his colleagues – even reputedly “dovish” ones – are openly talking about the need to speed up “tapering” and end asset purchases early, thereby setting the stage for “liftoff” of the federal funds rate from the zero to 25 basis point target range it’s been in since March 2020.
On Nov. 30, eight days after President Biden announced his renomination as chairman, Powell abruptly unveiled a new policy attitude in testimony before the Senate Banking Committee.
“It now appears that factors pushing inflation upward will linger well into next year,” he told the senators. “In addition, with the rapid improvement in the labor market, slack is diminishing, and wages are rising at a brisk pace …. We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched.”
Then, when answering questions, he said it’s “a good time to retire” the word “transitory” – a pretty good hint that that word will be gone from the Dec. 15 FOMC statement.
And Powell went further to suggest that inflation has become worrisome enough to speed up the firming of monetary policy:“We now look at an economy that is very strong and inflationary pressures that are very high and that means it’s appropriate for us to discuss at our next meeting — which is in a couple weeks — whether it would be appropriate to wrap up our purchases a few months early.”
It’s almost, a cynic might say, as if Powell, liberated from concern that his chairmanship might be terminated, now felt free finally to recognize that it’s only prudent to start turning down the flame under a boiling inflationary kettle.
More charitably, perhaps Powell and his FOMC colleagues deserve some credit for admitting they can no longer ignore brewing wage-price pressures and can no longer count on inflation being “transitory,” especially now that inflation expectations no longer seem so “well-anchored.”
There has been a steady evolution – if that’s the word for such a rapid transformation of Fed thinking – from a seemingly steadfast belief that monetary policy must remain in emergency response mode for a sustained period to achieve both “maximum and inclusive” employment and inflation “on track to moderately exceed 2% for some time.”
The FOMC was confirmed in its unprecedentedly stimulative monetary stance by the revamped “Statement on Longer-Run Goals and Monetary Policy Strategy” which it adopted with great fanfare in August 2020. Under this new policy framework, the FOMC turned its back on its previous preemptive approach of raising rates whenever tightening labor markets seemed to portend inflation rising above 2%.
The FOMC resolved instead to let the economy run hot – to allow inflation to run above 2% to compensate for past undershooting and to encourage higher inflation expectations in order to achieve as much employment as possible. The FOMC let it be known that, henceforth, “maximum employment” would be considered “a broad-based and inclusive goal” measured by “assessments of the shortfalls of employment from its maximum level” – not merely “deviations from its maximum level,” as the previous longer run policy statement had it.
Seemingly, the Phillips Curve theory and its policy implications had been repealed. They made no bones about it.
Powell and other policymakers were proudly trumpeting their new job-friendly framework well into the second half, demonstrating a reluctance to part from its stimulative dictates.
Not only was elevated inflation deemed ‘transitory” until just a couple of weeks ago, but rising inflation expectations were dismissed, if not welcomed. Some even continued to express concern about a possible return of disinflationary trends.
In late September, for example, Chicago Federal Reserve Bank President Charles Evans said he was “more uneasy about us not generating enough inflation in 2023 and 2024 than the possibility that we will be living with too much. My concern is that when the Covid distress ultimately recedes broadly around the world, we will not have been freed from the downward bias on inflation imparted by the ELB (effective lower bound).”
But mounting evidence of wage-price pressures, coupled with a tightening, albeit idiosyncratic, labor market, started to change policymakers’ minds in a big way.
Amid surging demand for often scarce goods, the consumer price index rose 0.9% in October – up 6.2% from a year earlier, the fastest pace since 1990, and the fifth straight month above 5%.
In their latest outlook survey, members of the National Association for Business Economics expect inflation to moderate somewhat next year, but remain well above target.
The price index for personal consumption expenditures (PCE), the Fed’s preferred inflation gauge, doesn’t look a lot better. It was up 5% over the 12 months ending in October.
Both market and survey measures of inflation expectations have shot higher, although the Fed can take some comfort from longer term expectations. Financial markets were registering their concerns.
Equally worrisome is the trend in wages. Fed officials have been reluctant to conclude that the economy has entered an old-fashioned “wage-price spiral.” But following years of under-performance, the data show labor compensation doing its best to keep up with price increases as employers desperately sought to lure workers. The closely watched Employment Cost Index jumped 1.3% in the third quarter, fastest pace in 20 years or more, and monthly wage measures have shown the same uptrend.
The November employment report, far from diverting Powell & Co. from their more hawkish attitudes, likely reinforced their monetary firming proclivities, despite the disappointing non-farm payroll gain.
Average hourly earnings were up 4.8% from a year ago, following an eighth consecutive month of gains. Earlier, the beige book survey, prepared for the upcoming FOMC meeting, showed that “nearly all Districts reported robust wage growth” through Nov. 19.
“Hiring struggles and elevated turnover rates led businesses to raise wages and offer other incentives, such as bonuses and more flexible working arrangements,” the Fed report added.
That same week, the Institute for Supply Management’s November manufacturing survey revealed that “all input costs are going up considerably, across the board.”
True, non-farm payrolls rose a much less than expected 210,000 last month, but the Fed has made clear it’s the “cumulative’ amount of payroll gains that matters. Moreover, not only did the unemployment rate fall to 4.2%, but labor force participation – a big Fed concern – rose more than expected to 61.8%.
There were still 2.4 million fewer participants than before the pandemic levels in November, but the labor market seems well underway toward fulfilling the Fed’s “maximum employment” goal.
Already, of course, the FOMC had judged, at its Nov. 2-3 meeting, that “substantial further progress” had been made to taper. To lift the funds rate off the zero lower bound, the FOMC wants to see actual achievement of maximum employment. We’re not there yet, but we seem to be moving apace in that direction, despite the labor market’s many quirks.
This kind of evidence has forced a change of heart among FOMC members. Mere weeks after deciding to start tapering, they are now seriously contemplating augmenting it.
St. Louis Fed President James Bullard, who will be a voter next year, said in early December he’d like to end asset purchases in the first quarter so that the FOMC could “soon” get to a point where every meeting would be “live” for potential funds rate hikes.
Fed Governor Christopher Waller, who was Bullard’s top advisor before joining the Fed Board of Governors, has made similar noises.
Even the more dovishly inclined Mary Daly, president of the San Francisco Fed, has moved dramatically in a more hawkish direction.
In early December she anticipated that funds rate increases will be pulled forward into 2022, and said she expects FOMC participants to project at least two rate hikes when they publish a revised “dot plot” in the Summary of Economic Projections (SEP) on Dec. 15.
In the September SEP, half of the 18 FOMC participants projected one or more rate hikes next year. It seems likely that number will go up sharply in the December SEP. It would be surprising if a majority don’t project a 2022 liftoff. The only question is how many rate hikes are projected for next year and beyond.
Certainly financial markets have ramped up their rate expectations, pricing in three rate hikes beginning in June. Some now think liftoff could come even sooner.
Seemingly cementing the Fed’s more hawkish tendencies is the new emphasis on inflation-conscious “risk management,” as expressed in the minutes of the Nov. 2-3 FOMC meeting: “Participants stressed that maintaining flexibility to implement appropriate policy adjustments on the basis of risk-management considerations should be a guiding principle in conducting policy in the current highly uncertain environment.”
“Risk management,” of course, can mean different policy choices in differing circumstances, but in the current context of heightened concern about inflation and inflation expectations and adequate progress on employment, that passage in the minutes seems to imply that the FOMC is giving itself more leeway not just to taper faster but also to raise rates sooner and/or more steeply.
This approach almost seems to harken back to the kind of preemptive policies the Fed was infamous for before adoption of its new framework. It’s reminiscent of the FOMC’s rate hikes during the 2015-18 period, except that now we have the FOMC looking to firm monetary policy well before full achievement of maximum employment, as redefined.
Whether the FOMC pulls the trigger on faster tapering at the Dec. 14-15 meeting or not, we are likely looking at an earlier end to asset purchases and, hence, an earlier liftoff for the funds rate, assuming a continuation of recent trends on inflation and employment.
Powell’s comments about faster tapering have to be taken very seriously. At the very least, the FOMC seems likely to conditionally signal an earlier end to tapering and, hence, an earlier liftoff on Dec. 15.
It’s important to recognize, however, that almost no one is contemplating adoption of a truly restrictive credit stance — or even moving the funds rate to a “neutral” rate of around 2.5% — anytime soon — merely making policy less stimulative.
Even if the FOMC doubles the pace of tapering to $30 billion on Dec. 15, Powell can be expected to reiterate that, even after purchases end, monetary policy will stay accommodative and apt to stay so for the foreseeable future.
So far and so fast have expectations moved, that one has to wonder whether they have gone too far. As the Fed keeps reminding us, there is extraordinary uncertainty about the economic outlook, and as Powell took pains to tell the Senate Banking Committee, “downside risks” remain.
Indeed, Powell seemed to give the Fed an out when he told the panel, “The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation. Greater concerns about the virus could reduce people’s willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions.”
And other downside risks could easily be cited. So there is no guarantee that the Fed will stay on course for significant credit tightening over the coming year.
It’s also important to realize that there are probably going to be built-in limits to the amount of Fed tightening that is feasible. For one thing, to the extent the Fed raises rates, the U.S. dollar would tend to appreciate and undermine economic growth. Dollar appreciation would undoubtedly help contain wage-price pressures, but it would also subvert the goal of maximum employment.
Secondly, the Fed Board will be increasingly composed of Biden appointees, who are less likely to support monetary tightening.