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Will The Fed Keep Inflation Contained?

By James PicernoMarket OverviewJun 22, 2021 04:47PM ET
www.investing.com/analysis/will-the-fed-keep-inflation-contained-200587549
Will The Fed Keep Inflation Contained?
By James Picerno   |  Jun 22, 2021 04:47PM ET
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Inflation has surged recently, raising concern that the US economy faces its biggest threat to pricing stability since the 1970s. The counterargument: inflation is transitory and the recent run-up in prices will fade as production bottlenecks linked to the economy’s reopening fade. Even if inflation turns out to be more persistent than some forecasters expect, the Federal Reserve will step in and nip the problem in the bud.

The last defense against higher inflation, not surprisingly, is the central bank. That leaves the critical question: How much confidence should be assigned to presuming that the Fed will adjust monetary policy in a timely fashion if faster inflation is stickier than expected?

Skeptics say that the Fed’s track record on economic forecasting is hardly encouraging. To be fair, it’s not obvious that private economists are any better. Forecasting is hard for everyone, especially about the future.

Regardless, the government’s extraordinary pandemic stimulus threatens to permanently raise inflation, some analysts warn. If so, does the Fed have the tools to cap if not reverse higher inflation? Yes, but that leads to another question: Will the Fed use those tools in a timely manner?

Here’s where the outlook become hazy, in part because expectations on this front depend on whether you think the central bank has become overly politicized. One line of worry runs as follows: debt levels (for government and the private sector) have increased sharply in recent years and so higher rates will create burdens that the economy can’t tolerate.

There’s some truth in that concern, although the pushback is that if the Fed tightens policy sufficiently early, any upside inflation surprise will be curtailed and so interest rate hikes will be modest.

There’s also the potential for deploying hawkish Fed rhetoric as a tool to convince the markets that the central bank will remain vigilant on keeping inflation contained. There was a hint of this last week, when St. Louis Fed President James Bullard said that rate hikes may begin sooner than expected – comments that triggered a decline in commodities prices and Treasury yields.

There’s still a lot of uncertainty about inflation’s trajectory, but there are nascent signs that the recent surge is peaking. For example, a multi-factor measure of the directional bias for US inflation – based on The Capital Spectator’s Inflation Trend Index — continues to suggest that June will mark the high point for the recent swelling of pricing pressure.

Inflation Trend Index
Inflation Trend Index

In addition, the Cleveland Fed’s inflation forecasting model projects that after this year’s pop in prices, the trend will ease in the years ahead. For example, over the next five years this model sees inflation at around 1.5%. Every model is wrong, but some are useful. On that point, Mark Hulbert at MarketWatch.com reports that the Cleveland Fed’s model has a relatively strong record vs. the University of Michigan’s consumer survey of inflation expectations and the Treasury market’s implied inflation outlook.

Keep in mind, too, that political pressure will probably rise for the Fed to act if inflation appears to remain higher than expected. It’s likely that if and when the Fed appears to be losing control of inflation, Fed Chairman Powell will be mercilessly pressed to explain why at the periodic public hearings in Congress.

Meanwhile, Fed policymakers are starting to talk about tapering bond purchases, a shift that — when it comes — would likely be an early sign of monetary tightening. Although tapering isn’t expected in the immediate future, the fact that the subject is receiving public attention from the central bank lays down markers that the potential for change is brewing.

“It would be healthier as we are making progress in weathering the pandemic and achieving our goals to start adjusting these purchases — Treasuries and mortgage-backed securities — sooner rather than later,” Robert Kaplan, Dallas Fed chair, noted on Monday.

As for the bank’s standard toolkit, Fed funds futures markets aren’t pricing in rate hikes for the rest of this year, but the estimated probabilities start to rise meaningfully in 2022, rising gradually to 40% a year from now, based on CME data.

Nonetheless, there’s plenty of speculation swirling that the Fed will intentionally remain asleep at the switch if inflation proves to be less than transitory. But for now, this is guesswork and there’s minimal, if any, reasoning to suggest that its captures a likely scenario for the months and years ahead.

The bigger risk is that the Fed remains attentive and acts responsibly but gets the timing wrong and allows the inflation genie to escape. But recent commentary from Fed officials suggests this is a misplaced concern, at least for now.

As Tim Duy at SGH Macro Advisers tells clients in a research note this week:

The Fed’s hawkish turn is primarily about a belated acknowledgement of the strength of the data rather than a shift in the reaction function. That said, within the reaction function there are still moving pieces to consider that provide some policy flexibility. The Fed’s decision to place a high priority on controlling the tapering discussion limited debate on those moving pieces and encouraged a widespread perception that the Fed was more uniformly committed to a particularly dovish interpretation of the data and framework than was the case. That perception cracked last week.

Will The Fed Keep Inflation Contained?
 

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Will The Fed Keep Inflation Contained?

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Comments (6)
Joel Schwartz
Joel Schwartz Jun 22, 2021 11:08PM ET
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Pull up a chart of the value of the USD since the FED’s inception in 1913. They couldn’t devalue our currency more if they nuked it from orbit.
Rob Fordham
Rob Fordham Jun 22, 2021 11:08PM ET
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I mean yea techincally that is true but if they didnt act in 08 we would not even have capitalism so u know trade offs
Joel Schwartz
Joel Schwartz Jun 22, 2021 11:08PM ET
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Rob Fordham I mean, in a free market good companies succeed and bad ones fail. In the FED’s economy, companies have negative revenue and are valued in the tens of billions of dollars.
simone scelsa
simone scelsa Jun 22, 2021 11:08PM ET
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Rob Fordham  what are you saying? They did act and we no longer have capitalism
Ron Tinari
Ron Tinari Jun 22, 2021 9:41PM ET
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The Fed couldn't balance my check book,
Rob Fordham
Rob Fordham Jun 22, 2021 9:41PM ET
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Something tells me u cant either
Colonel Forbin
Colonel Forbin Jun 22, 2021 6:27PM ET
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Can they unprint all of the money ?
Rob Fordham
Rob Fordham Jun 22, 2021 6:27PM ET
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Sure and they can take all ur money if they do is that what u want
William Bailey
William Bailey Jun 22, 2021 5:44PM ET
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Fed already lost control
Rob Fordham
Rob Fordham Jun 22, 2021 5:44PM ET
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Hardly its just the yahoos like u who think they are soo much smarter even tho they didnt graduate community college
Kenny Venezia
Kenny Venezia Jun 22, 2021 5:36PM ET
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they will try & fail
la popeye
la popeye Jun 22, 2021 3:56PM ET
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no, fed gov and the rich don t care of the value of usd. theywant dollars debase as commercial war is still raging.
Rob Fordham
Rob Fordham Jun 22, 2021 3:56PM ET
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Tinfoil hat is showing may want to tuck that back in
 
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