MNI INTERVIEW (CORRECTED): 'High Probability' of 2022 Fed Hike

(Corrects to make clear Pennacchi is a current Cleveland Fed visiting scholar, not a former staff member)

Mounting inflation pressures and soaring growth will likely force the Federal Reserve to raise interest rates sometime next year, well before the 2023 consensus implied by the central bank's own forecasts, Cleveland Fed visiting scholar George Pennacchi told MNI.

"There's a high probability that we'll see rates hiked in 2022," Pennacchi, said in an interview.

The first rate increase might even come early next year, he said, which would upend the Fed's desire to keep a distance between plans to taper bond buys and raise interest rates.

"At some point they're going to have to do both, reduce bond purchases as well as raise rates. It's going to depend on just how overheated the economy is."

Inflation readings over the last three months have been substantially higher than Fed officials and market participants had expected earlier in the year, with the consumer price index surging 5% in May and seen posting a similar gain for June.

Pennacchi, also an ex-visiting scholar at the New York Fed and one-time consultant to the central bank's Washington-based board of governors, believes inflation could register around 4.5% for this year as a whole and as high as 4% next year -- double the Fed's official target.

The central bank's June decision to raise the interest it pays on bank reserves was a sign that officials already recognize there's too money sloshing around in the financial system, he said.

"They mentioned that that was a technical change but in the sense that was the start of raising rates," he said. "The effective federal funds rate will now be higher than it was over the last few months. It was averaging below 10 basis points and now it's probably going to move up a little bit. So that's a very mild rise in rates already but it might be a testing of the waters."

The combination of a system in which the Fed pays interest on reserves, first implemented in the depths of the Great Recession, and a sharply expanded fiscal stimulus policy is potentially troublesome, added Pennacchi.

"If inflationary pressures do persist, and there is this need to raise rates it's going to be more expensive than it was in the past because the Fed is paying interest on reserves," he said. "The Fed is going to have to be paying interest on reserves that's less seigniorage that's going to be going into the Treasury. That could exaggerate the inflationary pressures."

FISCAL FACTORS

Echoing concerns expressed by a number of former and some current Fed staffers and advisers, Pennacchi said the shift in fiscal policy toward a much more proactive stance had fundamentally altered the inflation outlook in a way that the Fed's recent framework shift toward a more dovish pro-employment stance ignores.

"The surprise of the Biden administration is just how stimulative their proposals are in fiscal policy," he said. "It seems like in most of Washington there's just no thought about the size of deficits and debt and that's just going to create a lot of financing needs of the Treasury that the Fed is going to have to soak up."

That could complicate the process of tapering the current monthly pace of USD120 billion bond buys, which Wall Street sees taking place sometime in early 2022.

"The Fed is in some ways going to have to accommodate whatever fiscal policy ends up being implemented in terms of their bond purchases if they want to keep interest rates at some pre-specified level," he said. "We've been somewhat lucky up to this point that there's been strong demand for U.S. Treasuries but that may not go on forever."

Pennacchi said money market funds have become a captive but fickle buyer of government bonds whose liquidity has been shown to evaporate in times of stress.

"Money market funds have in some sense transformed from funds holding private securities like holding commercial paper to now just holding U.S.Treasuries and government securities. But I think that's fragile and we could easily see outflows at some point."