MNI INTERVIEW: Fed to Push Off Taper, Look Through Inflation

Federal Reserve officials are so keenly focused on seeing actual job market gains before tightening monetary policy that they could wait until well into 2022 before tapering bond buys, Yuriy Gorodnichenko, a visiting scholar at the San Francisco Fed, told MNI.

"The Fed will continue to push on the gas pedal if strong employment gains don't materialize," he said in an interview. "My guess is that they will keep stimulating the economy with all means for another year and then gradually taper the support."

That would be a lot longer than Wall Street's timeline, which now centers around some kind of fall announcement for a year-end start to the taper.

Gorodnichenko, who studies inflation and inflation expectations and was a presenter at last year's Kansas City Fed Jackson Hole conference, says he saw the risks of inflation as still tilted to the downside despite recent unexpectedly sharp spikes that he, like Fed Chair Jerome Powell, sees as largely transitory.

"The risks are so one-sided. Having inflation at 3 or 4% for a year or two that's not super costly, if you have inflation at zero for two or three years, that's a problem," he said, pointing to repeated run-ins with the zero lower bound by the Fed and other central banks.

WAITING FOR EPOP

"I don't think we're going to have a chronic problem with inflation," Gorodnichenko said. "We have enormous slack in the economy. The employment-to-population ratio we see today is at the level we saw at the trough of the Great Recession, the worst months."

Indeed, a June EPOP of 58% is below the Great Recession's lowest reading of 58.3%, and has substantial ground to recover before getting back to pre-Covid levels around 61%.

Fed officials expect workforce participation and employment to pick up steam around when schools are expected to reopen in September, but supply chain disruptions and widespread job market mismatches could prove this presumption optimistic.

"The experience after the Great Recession is that we have a lot of capacity to create jobs and absorb people back into the workforce," said Gorodnichenko, who has been a visiting scholar at the SF Fed since 2009, and a research consultant at the ECB since 2018.

The Fed said at its meeting this week the economy has "made progress" toward goals of full employment and price stability but more was needed, particularly on jobs, before it could begin to pare back support for the economy by cutting back on a monthly USD120 billion QE program.

Powell said the labor market is "some way away" from having made enough strides to cut back on QE.

INFLATION HEADFAKE

The inflation side of the Fed's mandate also calls for patience despite recent scares like a 5.4% jump in the year-on-year CPI for June, which jolted financial markets and prompted some political pushback, Gorodnichenko said.

His research indicates that the inflation expectations of consumers are so well anchored at low levels over the long run that short-lived price spikes in specific sectors like used cars or in services linked to reopening, such as hotels and airlines, will not have an impact. (See MNI: Patience Warranted As Inflation to Ease-Ex-Fed Economists)

"The Fed has been so credible at keeping inflation low and stable for so many years that people just don't pay attention," he said. "For most people fundamentally it's not going to register, especially if it's not persistent."

Chair Powell told reporters following this week's policy meeting the United States "won't have an extended period of high inflation," emphasizing that one-time, localized price increases do not constitute inflation per se.

Gorodnichenko said the Fed was arguably too successful at tamping down inflation expectations, forcing it to lower rates to ever lower levels until it ran out of traditional monetary ammunition and was forced to resort to QE.

"If you ask an average American what the Fed's policy is, this average American is going to ask you 'what is the Fed?' And when you tell this person well, we have QE, we have forward guidance, we have all these tools, something that could potentially ignite a lot of inflation, most people will have no idea what you're talking about. In a way it's a sign of success."

Gorodnichenko's 2020 Jackson Hole paper argued the Fed's framework shift should focus on the positive gains from stronger economic momentum rather than touting the benefits of higher inflation, which could be misinterpreted by the public. He said officials have clearly taken his and his co-authors' advice to heart.

"The Fed has moved more towards emphasizing employment -- and more broadly the health of the economy-- and not talking about wanting to have more inflation," he said.