It's Time to Accelerate Tapering
Inflation numbers released last Friday by the Bureau of Labor Statistics showed an annual increase of 6.8% in the Consumer Price Index, a figure larger than any month on record since 1982.
This number, in and of itself, is no cause for alarm; however, when we examine it within the larger economic context—in particular, the fact there have been six straight months of higher-than-expected inflation—an alarming picture begins to form, and when we juxtapose that picture with the one the Fed forecasted months ago (and even the one Federal Reserve Open Market Committee (FOMC) described in its November meeting), it’s easy to see things are getting a little out of control.
What is most concerning is where the Fed is in the tightening process. There are quite a few steps the central bank needs to take before it can make notable strides in countering prevailing inflation. The Fed can’t just raise the policy rate and inflation miraculously subsides; it’s far much more complicated than that. The Fed has expanded its balance sheet to such a large degree, buttressing numerous markets using a diverse set of policy tools, that widespread tightening is going to be more challenging, more protracted, and more disperse than what market players have historically come to expect. Because of this, it is imperative the Fed drastically decelerate its monthly asset purchases.
In practice this means the Fed should unwind its support of long-dated treasury and mortgage-backed securities (MBS) bought each month through its markets desk at the Federal Reserve Bank of New York before the bank takes steps to adjust the policy rate explicitly. Purchases of short-term Treasury securities are a vital component of Open Market Operations—the primary tool which influences the policy rate—and expansive purchases of MBS, corporate debt, and long-dated treasury bonds have proved vital in helping stabilize markets during the challenges of Covid this year and last, but with the level of inflation seen over the past few months, the market is telling us expansive monetary support is no longer necessary, something the Fed could be overlooking.
At the last FOMC meeting, the FOMC stated in its public release, “Inflation is elevated, largely reflecting factors that are expected to be transitory. Supply and demand imbalances related to the pandemic and the reopening of the economy have contributed to sizable price increases in some sectors. Overall financial conditions remain accommodative, in part reflecting policy measures to support the economy and the flow of credit to U.S. households and businesses.” (Emphasis italicized)
There are two points to take away from this, the first of which is that the Fed is starting to test our credulity with all its talk of inflation being “transitory.” After seven straight months of 5%+ inflation, and few reasons to believe things will change anytime soon, the Fed needs to come to terms with the fact that the current bout of inflation is anything but transitory. Perhaps it could have been transitory had the FOMC taken bold steps to raise rates earlier this summer, but doing so would have been detrimental to employment and growth at precisely when the future of the American economy was in question.
Having said all of this, just because inflation has not proved transitory, it doesn’t mean the Fed should go ahead start raising rates. The Fed should not raise the policy rate—at least not yet. The Fed should, however, decelerate its asset purchases and begin the tightening process by using the tools at its disposal to influence economic conditions through means other than the interest rate channel—which brings me to my second point: the reason inflation has failed to prove transitory is because the Fed has kept financial conditions accommodative, and until these conditions change, inflation will persist.
Inflation will come down eventually—either through an economic shock that disrupts markets to the point where prices begin to fall and the economy dips into recession, or through tighter borrowing conditions brought about through higher interest rates.
The Omicron variant certainly poses risks for a slowdown, but few policymakers believe it will present a near-term, recession-scale shock that lowers prices. So if policymakers want to tackle inflation in the near-term, while keeping the economy of a stable growth path, they need to start acting with some urgency by paving the way for eventual rate increases.
This week we will see what actions the FOMC plans to take and whether they will shoot us straight on inflation, or if they will continue the narrative of inflation being “transitory.” Each committee member knows that allowing inflation to take hold of consumers’ and businesses’ price expectations—where price increases become self-fulfilling, priced in factors of production—would be a major policy failure on the part of the Federal Reserve. That being said, preventing such an outcome isn’t something the committee can orchestrate overnight. We should expect high inflation numbers in the months to come because too much has to be done before the US economy enters a “tight” monetary environment.
At the meetings today and tomorrow, the Fed needs to take this opportunity to be more transparent with us about the challenges that come with monetary tightening, the timetable it needs to conclude its tapering process, and the likely market reaction from tighter financial conditions.