MNI EXCLUSIVE: Fed SEP Must Show Sustained Inflation For Hikes

The Federal Reserve will require a sustained rise above 2% inflation in its quarterly forecasts before considering hiking interest rates, former top central bank officials told MNI, pointing to communications challenges ahead if growth accelerates as the Covid pandemic eases.

The Fed's quarterly three-year forecasts include outlooks for inflation, growth and employment, and this Summary of Economic Projections would need to point to consistently above-target inflation as the committee seeks to solidly anchor inflation expectations around 2%, they said.

Investors betting on the Fed to blink at early signs of price increases are underestimating the shift in thinking at the central bank with regards to economic slack in the wake of a decade in which inflation fell repeatedly short of target, ex-Fed officials with knowledge of the forecasting process said.

CALLS FOR PATIENCE

The SEP inflation requirement goes beyond Fed Chair Jerome Powell's broad calls for patience during his press conference this week, or Vice Chair Richard Clarida's recent comment that "we are not going to lift off" until annual inflation reaches 2% for a full year.

"They're not going to raise interest rates until you have a modal forecast around most of the committee where everyone sees inflation steadily above 2%," said Jeff Fuhrer, former Boston Fed executive vice president and senior policy advisor. "They at least need to have a strong prospect of inflation above 2% consistently."

The central bank is trying to stabilize inflation expectations at 2% and wants to signal this commitment with a sustained overshoot, Dennis Lockhart, former president of the Atlanta Fed, told MNI, noting that the framework shift also places renewed emphasis on a more inclusive definition of full employment. The personal consumption expenditures index has registered annual growth just above 1%.

"They're looking at several months, as much as a year, of PCE inflation both headline and core, ideally both running above 2% and they're going to use the 12-month measure as a key indicator among the inflation data," he said. "Then they are going to look for supporting evidence in an array of other inflation readings-- CPI, trimmed mean, sectoral price changes. Headline PCE is their official benchmark but in fact they look at a real dashboard of inflation indicators."

Speculation about a possible rise in inflation picked up steam after Joe Biden's election win and Democratic Senate victories in Georgia raised chances of more aggressive fiscal policy, with the new president proposing a USD1.9 trillion package. Five-year TIPS breakevens, a measure of inflation expectations, recently rose to 2.18%, their highest since 2013.

COMMUNICATION CHALLENGES

Fed communication aimed at avoiding unwanted tightening of market conditions will have to be sustained when the recovery picks up steam in the second half of the year. Some regional Fed presidents may also fret that any stronger-than expected growth might be inflationary.

"They are trying to say they will let inflation rise above 2% for a while but they will start getting worried about the dynamics if inflation starts to rise," said Dean Cruoshore, a former executive vice president and economist at the Philadelphia Fed, told MNI.

Ex-Boston Fed economist Fuhrer agreed: "There are still some presidents who will be nervous as the economy gets to their estimate of full employment."

Ex-Richmond Fed President Jeffrey Lacker told MNI recent experience of low inflation gives the Fed reason to be skeptical of price spikes expected as base effects feed through from last year's slump. But he also pointed to a lack of clarity from policy makers as to how exactly they see QE and low rates working to support the economy--and how the withdrawal of such assistance might be engineered in an orderly fashion.

"I worry that without a firm handle on the transmission mechanism they're not going to see inflation coming and it's going to break out," said Lacker.

TAPER TANTRUM

Markets are most immediately focused on the Fed's QE program, which policy makers are likely to reduce well in advance of rate increases.

With the 2013 "taper-tantrum" a painful memory, Fed Chair Powell emphasized his desire for patience before any talk of policy tighten or reducing USD120 billion in bond buys. "The whole focus on exit is premature," Powell said. "It's just too early to be talking about dates."