Are They So Sure?
Not long ago, central bankers and investors steadfastly believed that the 2021 burst of inflation would be temporary. Suddenly, that’s unfashionable. Chastised by a growing chorus of critics and confronted by high inflation, the Federal Reserve, the Bank of England, and the European Central Bank have thrown in the towel on transitory.
The bond market is also ratcheting up the pressure. It now firmly discounts three quarter-point Fed rate hikes this year — with growing odds of a fourth — followed by more tightening in 2023. And why not? This past week, the Federal Open Market Committee (FOMC) December minutes revealed very hawkish attitudes, with many members even contemplating asset sales concurrent with rate hikes. In the brief history of quantitative easing, that double-barreled tightening would be unprecedented.
In short, over the past few months, global monetary policy has performed a stunning and historic U-turn. Investors have taken note, with a wobbly start of 2022 for global equities, punctuated by bigger selloffs in growth stocks and styles.
But just as many questioned the Fed’s confident assertions of ‘transitory’ six months ago, it’s worth asking, are they sure they have it right now?
After all, the stakes are high. Indeed, they are much higher than whether the bull market can endure. Millions of jobs rest on the Fed getting it right. Moreover, what would once have been hyperbole is no longer inconceivable — a major Fed policy error could deal a mortal blow to its credibility or even to US democracy. This may sound extreme, but few dynamics undermine a country’s stability faster than an economy in crisis.
So, what has changed to change central bankers’ views?
First, inflation has accelerated. US core personal consumption inflation is now at 4.7% and has jumped in the most recent reporting months. In the Eurozone, the ECB’s preferred inflation measure hit 5.0% in December. In the UK, consumer prices are rising 5.1%. In all three regions, inflation is well above central bank target ranges. For context, the Fed’s long-term inflation target is 2%.
Second, although ‘transitory’ was never specified, it appears that inflation is proving more persistent than previously thought. Concerns about persistence are growing given an acceleration of wage growth, lending a potential cost-push element to existing price pressures.
Third, there appears to be a growing belief among central bankers that damage was done by the pandemic, as well as other factors, including demographics, reverse globalization and changing worker habits, have reduced the economy’s speed limit. The economy may already be operating near its potential. If so, some cooling of demand would be warranted to prevent higher inflation expectations from becoming entrenched among households, businesses, and financial market participants.
One thing is not in dispute — inflation is higher today than anyone forecasted a year ago. But the other factors driving new-found central bank hawkishness are less clear-cut.
It is worth recalling that persistent inflation requires persistent excess demand, recurring negative supply shocks, rising inflation expectations, or some combination of the three.
Let’s begin with demand. At the end of 2021, IMF estimates suggest that total real (inflation-adjusted) spending by the private and the public sectors in the high-income economies of North America, Western Europe (including the UK) and Japan was roughly what it was before the pandemic struck in Q1 2020. Even in the US, real GDP is only marginally above its pre-pandemic peak. As strong as recoveries have been over the past 18 months, total spending and output is only back to where it was two years ago. If the economy’s potential has expanded since then, the implication is that the output gap has not yet closed.
Accordingly, it is difficult to argue that the advanced economies are suffering from significant excess aggregate demand. Instead, spending patterns have shifted to goods and away from services. Demand for ‘higher risk’ services such as travel, lodging and dining away from home has slumped, while demand for tangible goods has surged. As a result, goods price inflation has outpaced services inflation, which is running 1.3 percentage points slower than overall (core PCE) inflation.
Nor have inflation expectations become dislodged. At 2.8%, five-year US inflation expectations derived from Treasury Inflation Protected Securities (TIPS) are lower than they were in November and are roughly at the same level as in May 2021. The University of Michigan’s survey of household’s expected one-year inflation is higher, at 4.9%, but it has reached similar levels before (for instance, in 2005, 2008 and 2011) without presaging a sustained inflationary episode.
On the supply side, bottlenecks and frictions are proving to be more stubborn and widespread. Above all, the labor market is responding sluggishly. Despite output reaching its pre-pandemic peak, US total employment is lower today by some 3.6 million jobs compared to February 2020. To wit, the labor force participation rate has become mired at 61.9%, below its 63.4% pre-pandemic level.
In short, high inflation today is not solely or even primarily about surging demand. Nor are rising inflation expectations at work. Rather, shifting spending patterns, sluggish labor supply and other production/distribution impediments are pushing up goods prices, less so services prices, faster than anyone forecasted.
First, central bankers should recognize the importance of shifts in relative prices. Monetary policy should accommodate (not resist) them, as they signal to households and firms to redirect savings and investment to where shortfalls create attractive opportunities.
Second, tightening monetary policy is problematic if the economy is suffering from impaired supply. Tightening enough to slow demand growth only makes sense if supply rigidities in production, distribution and labor have fundamentally changed the economy and its trend growth, or if current inflation is changing behaviors about future inflation.
A year ago, we warned that inflation would be a major story for 2021. It was. More recently, we have written that inflation may be overestimated, and that it is more likely to crest and recede than remain near its current elevated levels. Accordingly, we are concerned that central bankers may be mistaking the drivers of inflation, potentially setting them — and us — up for serious policy error.