Breaking Trust with the Fed on Inflation
The Fed has made it clear they will tolerate 3%+ inflation for a period of time to make up for the low rates of inflation during 2020. The Fed is likely hoping/guesstimating that slow growth in 2022 along with favorable YOY price comparisons will get them to the promised land of not having to deal with inflation through higher rates in 2021.
Like everything in DC, it’s more complicated than perceived and we shouldn’t expect the central bank to get this right.
For starters, the financial markets and economists have focused on inflation data for several weeks leading up to Tuesday’s CPI release. The media has been reporting daily on rapid increases in a wide range of prices from used cars to diapers to lumber to housing to gasoline to palm oil. I’ve been stunned by the sanguine nature of both well-known economists and officials at the Federal Reserve indicating the rise in prices is “transitory” and won’t require action by the central bank. Given prognosticators massive miss on Friday’s employment data, we should’ve seen this coming.
This week, they were all shocked, shocked by the 4.2% jump in US CPI with Federal Reserve vice chairman Richard Clarida stating the obvious: “I was surprised. This number was well above what I and outside forecasters expected.” I think only those that weren’t looking at commodities, chip bottlenecks and housing were surprised. Today’s 6.2% PPI number reinforces and supports the surging inflation story.
Why do these economic elite keep saying the recent acceleration in prices will prove to be transitory? Are they Ralph Waldo Emerson’s statesmen? From my view, there are 2 major drivers of their beliefs.
The strongest argument for patience on our current spate of inflation is that it’s generated by reopening of the economy after the shutdown. As Clarida states, the economy is working through supply and demand mismatches which occurred during the pandemic. This is partially true, but the massive stimulus generated by both the Federal Reserve and the 4 federal spending bills is doing the heavy lift. Remember, this amounts to over $12.4T and not all of it has been dispersed or spent by consumers. In other words, the central bank and the federal government are engaging in procyclical inflation activity as the economy is already growing at 3x trend or 6%+ GDP.
Why are they doing this?
Both the Biden administration and the Federal Reserve tell us the thrust of policy is to return to pre-pandemic employment levels for all workers with a focus on a “broad-based and inclusive goal.” This was a change in the Fed’s policy last August and is a shift to acknowledging the benefits of a strong labor market for low- and moderate-income workers. Under the Trump administration, the Powell Fed learned they can run monetary stimulus for longer as the unemployment rate dropped without an inflation pickup. If they are using this playbook, they aren’t adapting to the significant change in fiscal policy, regulations and unemployment benefits with the reopening.
Former chairman of the White House Council of Economic Advisers Kevin Hassett puts it this way: “the Biden Administration is providing the biggest positive stimulus to demand since WWII, and at the same time doing everything it can to suppress supply. Higher [unemployment insurance] benefits, closed schools (which keep one parent at home), and promised corporate tax hikes practically guarantee that supply can not keep up with demand. It is a recipe for an inflation shock we have not seen in the U.S. in a generation.” (WSJ)
The second salient argument for the Fed’s inflation patience is the highly likely slowing of the US economy in 2022. The Biden administration is currently pushing $4.0T+ in new spending with the American Jobs Plan (AJP) and the American Family Plan (AFP) to address physical and social infrastructure policies. It’s unlikely he’ll get more than $1T of new spending for the AJP. The AFP will be dependent on holding together a graphene thin House majority of 6 and a 50/50 Senate. By my estimates, we’ll see a significantly slower economy in 2022.
This is the risk for our central bank. With the Biden administration, the Fed is creating the conditions to drive inflation higher, and they may not be able to or have the ability to control it. Yes, they can react by raising interest rates and tapering. The question will be do they have the political stomach for it? Can the Fed risk slowing down the economy in 2022 when there will be a midterm election?
If you think this is far-fetched, think about current Fed chairman Powell and his job status as his term ends in February 2022. If Powell wants to keep his job, he will likely be bending to Biden/progressive pressure to keep monetary policy at the current heightened, emergency level. If not, Minnesota Federal Reserve President Neil Kashkari is a possible replacement with a political bent and policy beliefs aligned with progressives. Remember, President Trump broke tradition by firing Janet Yellen and bringing in Jay Powell…a fact I’m sure Yellen has reminded Biden about since becoming Treasury Secretary. A Kashkari nomination would create additional inflation momentum, higher bond yields and a quagmire for stocks.
As we just learned, the elite economists and Federal Reserve members can be startled when reality shows up. The inflation reality is upon us. The reality of future economic damage could be coming. And no one should be surprised.