MNI INTERVIEW: Andolfatto Says Fed Must Be Ready to Hike

Simmering U.S. inflation pressures will likely abate next year but the Federal Reserve should be prepared to raise interest rates if the recent spike proves sticky, St. Louis Fed economist David Andolfatto told MNI.

"If this inflation turns out to be more persistent than what we thought, I think that might motivate the FOMC to act to raise rates" in 2022, he said in an interview.

Policymakers are right to begin tapering bond purchases soon, Andolfatto said, as they are expected to do as early as next month's meeting.

He is less focused on supply-chain worries dominating market concerns and more on the outcome of a contentious fiscal battle in Washington.

"My feeling is that inflation will likely dissipate but much of that feeling will depend on how the economy progresses and in particular the fiscal side of things," he said.

"What will be the fate of the two big spending packages for example? If your inflation forecast depends in part on developments in fiscal policy, that's really difficult because you're asking me to forecast politicians."

Lawmakers in Congress have been wrangling over two major fiscal deals that add up to trillions in additional spending but face substantial political challenges.

"The impact on cost pressures might depend in part on those packages but also on how fiscal policy is likely to develop beyond that," Andolfatto said.

WAGE-PRICE DYNAMIC

Officials must also stay cognizant of the risk that higher inflation readings will become embedded into consumers' expectations and behavior.

U.S. consumer prices jumped 5.4% in the year to September, a fifth month of readings above 5%. The Fed's preferred PCE measure rose 4.3%, more than double the central bank's 2% target.

"My view on what the cost of living is going to do over the next year or two years might lead me to approach my employer and say, 'Listen, my rent is going up, my grocery bills are going up, I'm talking to everybody, we're saying you're going to have to do something about this, and oh by the way, we can see that you're selling all your stuff at higher prices too,'" Andolfatto said.

U.S. inflation expectations as measured by the UMich and New York Fed surveys have been marching higher while market-based inflation expectations derived from inflation-protected Treasuries have hit 16-year highs.

FISCAL FACTORS

Still, Andolfatto said, the underlying fiscal stance will affect whether such embedded expectations are actually realized.

"If these bills get shut down and we go into austerity mode, it would be hard for me to see how the inflationary pressure could persist," he said.

"People might believe inflation is going to be high but if it doesn't transpire because people's support payments are getting cut, their transfer payments are getting cut, the government continues to lay off workers and not renew contracts -- it's not entirely clear that it could become self-fulfilling if you don't have the underlying support."

He said the economy has made significant strides toward the Fed's full employment goal, but additional work is needed before returning to pre-pandemic levels, even if the post-covid job market looks quite different. "We may not be all the way there yet but we're making progress," he said.

The jobless rate has fallen sharply, to 4.8% in September, but the economy remains some 5 million jobs short of pre-pandemic levels.

The path of inflation and market interest rates also depends on the global demand for Treasuries and dollars, Andolfatto said, noting commentary suggesting that China may want to further run down its holdings of U.S. debt.

"I'm hearing stories of China now kind of wanting to unwind its holdings of U.S. Treasury securities," he said. "That's something that one has to take into account."

While bond markets have avoided a 'tantrum' because of the gradual nature of the Fed's QE tapering announcement and because the move is coming on the back of an economic boom, it's important to watch the supply-demand balance of Treasury issuance and global buying, he said.

COMMUNICATIONS DILEMMA

Andolfatto said the Fed is having a hard time explaining to the public what "transitory" inflation actually means because the term may not comport with the lived experience of most people.

"It's entirely possible for the inflation rate to blip up and come down -- that would be transitory -- but the price level in that example would be permanently higher. So the cost of living isn't 'transitorily' lower," he said.

"Most people would say, you increased my cost of living forever. There's nothing transitory about that. This creates a lot of anxiety for people, they're worried about whether their wages are going to keep up."