MNI: Fed Could Tighten Policy Sooner if Price Pressures Surge

Simmering price pressures could force Federal Reserve officials to speed up their QE exit and interest-rate liftoff timeline as they reassess how hot the economy can run without sparking undue inflation, current and former policymakers told MNI.

While some still see room for medium-term inflation expectations to rise after a decade of downside misses, supply chain bottlenecks and economic reopening could push them too high, leaving the Fed in the difficult position of needing to pare back monetary support before the string of million-plus increases in payrolls Fed Chair Jerome Powell has signaled might be needed, MNI was told.

"They've got to make sure they don't lose sight of their price stability mandate, particularly when it's unclear what maximum employment will be and what the right metrics are for measuring that," former Fed Vice Chair Don Kohn said.

"If higher inflation expectations are sustained and not just a reaction to increases in fuel prices, particularly after supply comes back online and people return to work and bottlenecks are cleared up, that would be a very serious sign they need to rethink the speed with which they engage in tapering."

The idea, common last year, that the Covid crisis might depress inflation has now been widely discarded, said Edward Knotek, a senior vice president and research economist at the Cleveland Fed, in an interview. Now the question is whether a spike in prices caused by supply constraints will feed through into a sustained push higher.

"Whether people are going to be bargaining for higher wages is an open question," said Knotek, who has been tracking consumer expectations in a rolling survey throughout the Covid crisis. "But anecdotal evidence suggests wages are moving up and have continued to move up and that's consistent with the higher inflation expectations we're seeing in the survey."

SHRINKING LABOR POOL

Even if hiring stays subdued into summer, Powell can note that claims for unemployment benefits are down, job openings data are strong and wages are rising. Several Fed policymakers have recently remarked that labor markets are already tight.

"They've got substantial progress toward their inflation goals but not the employment goal necessarily. By the time they get to the June meeting, they'll get another month's worth of data and they could say we've actually started talking about taper," Kohn added.

Some also doubt that the pre-pandemic level of employment-to-population is attainable after the pandemic accelerated retirement and redefined the mix of skills sought by employers.

"The stock market is near an all-time high and housing wealth has also been very strong, so those who are close to retirement likely have their nest eggs intact, and it seems like they can probably stick with their decision. So I wouldn't really expect them to come back," St. Louis Fed President James Bullard told MNI in an interview this week.

Bullard said he's not ready to begin discussing a QE taper yet but remains mindful of rising inflation expectations -- and would become concerned if they were to pick up appreciably and further into the future.

BALANCED MANDATE

Inflation and inflation expectations that move up by more than the FOMC desires will also pull forward the Fed's timeline for rate hikes, even if the jobs recovery in minority communities falls short of the new more inclusive definition of full employment, the ex-officials said.

Former Fed Board economist Joseph Gagnon said September seems more likely a time for the Fed to start talking about tapering, with a January start date, "but all of these times could be shifted back or forward a few months," he told MNI.

"I believe they will be surprised by the persistence of inflation and be forced to raise rates earlier than they expect," he said. "Rate increases probably would start before tapering is completed," possibly as early as March 2022, "but they may also be associated with an increase in the pace of tapering."

Bill Nelson, another former Fed Board economist, told MNI: "If inflation expectations move up by more than they want, they very well could tighten even if they're not at maximum employment." The Fed's policymaking framework says if the two goals are at odds, they'll take both into account.

"My prediction is the minutes of the June meeting will indicate that they discussed how they plan to normalize their balance sheet, and after the July meeting, they will officially announce how they plan to do this, though it isn't the official start to tapering."