Fed under pressure to tighten rates more rapidly

Karsten Junius January 31, 2022 10:38

When the FOMC meets on 26 January, Chair Jerome Powell said that the U.S. labour market conditions are consistent with maximum employment, a milestone that comes nearly two years after the pandemic first wiped out more than 22 million jobs and that a March lift -off is very likely. Yet over the coming months, investors will, in all probability, question whether the more hawkish policy path towards a neutral stance is still too slow given the broadening inflationary pressures.

The market has significantly repriced its expected path of future rates hikes since the Fed’s aggressive pivot in December and the publication of minutes earlier this month. We didn’t expect major surprises when the FOMC met in Jan (given that it just changed tack), but there were a few things that Chair Powell had raised at the press conference. One is that the economy is getting very close to maximum employment, confirming the market’s view and ours that the first rate hike will probably come in March. Though we don’t expect the Committee to have made up its mind on the process behind the balance sheet runoff, Mr Powell confirmed that he will allow the authority to shrink balance sheet later this year, leaving rates as their main instrument to change the monetary stance.

In our view, over the coming months investors will assert that the new policy is still too conservative. Indeed, according to the Fed's own projections, the policy will only turn neutral in 2024. In other words, the policy will remain accommodative even if inflation is projected to remain above the 2% target and the unemployment rate falls below the Fed’s estimate of NAIRU (the unemployment rate that can be sustained without causing inflation to rise) throughout the whole period.

In short, there seems to be an obvious disconnect between the state of the economy and the monetary stance. True, as supply-demand imbalances shrink, inflation should drop. According to estimates by the San Francisco Fed, items that are sensitive to disruptions caused by the pandemic contributed to about three quarters of core PCE inflation last year. Still, inflationary pressures have clearly broadened out. The same estimates show that the annual inflation rate of items that are not sensitive to COVID-19 has picked up rapidly over the past six months. Other measures of underlying inflation, such as the trimmed mean or sticky CPI, paint a similar picture. And the broad-based increase in wage growth, captured by the Atlanta Fed tracker, suggests that the labour markets are very tight.

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Karsten Junius

Chief Economist, Head Economic Research at Bank J Safra Sarasin