MNI:Patience Warranted as Inflation to Ease -Ex-Fed Economists

The prospect of softer inflation readings over coming months and into early next year, reflected in a recent plunge in long-term bond yields, will likely give Federal Reserve officials greater room to wait for stronger employment growth before tightening policy, ex-Fed board economists told MNI.

Investors focused on a short-run spike in inflation may have missed a coming turning point, according to these staffers, whose views closely match those of Fed Chair Jerome Powell. Last week, Powell suggested policymakers need at least six more months to properly interpret data muddied by comparisons to the depths of Covid and by shifting labor market and supply chain trends.

"Inflation went faster to where we thought it was going to peak, and if that's the case, it can come down faster than we thought," Claudia Sahm, former Fed board economist and forecaster, said in an interview. "You could get (CPI) inflation back down to 3% by the end of the year, and start settling in at 2% by the middle of next year."

That would create breathing space for a central bank that has come under increasing pressure from investors and politicians to explain a sharper spike in consumer prices than expected, as the yearly gain in CPI hit 5.4% last month. The Fed's preferred PCE measure jumped to 3.9% in May.

"To the extent that today's inflation reflects a resurgence of demand, that inflation may well prove substantially temporary," David Wilcox, ex-director of the Fed board's Division of Research and Statistics, told MNI. "What we're seeing is a step-up of prices back to normal but little or no reason to expect further substantial changes either up or down from here forward."

As some supply chain constraints and other temporary bottlenecks are resolved, Wilcox said, "prices could decline, and in that case, today's rapid inflation could be replaced in some categories by substantial deflation and price declines."

Such expectations help explain a turn in bond markets that has seen 10-year Treasury yields plunge as low as 1.126% Tuesday, pointing to fears that growth -- and probably inflation -- has already peaked and is now slowing again.

WHAT GOES UP

Sahm said bringing down future forecasts for inflation based on higher-than-expected readings was common practice among Fed forecasting staff.

"If you get surprised on the upside with inflation, the first question is -- did we get the timing wrong?" she said.

"We thought used motor vehicle prices were going to moderate this month but they were going to stay high over the next couple of months, so did we just get those next couple of months right now? If that's what happened, that actually means you take down your forecast of inflation for those next two months."

A deceleration in inflation readings would buy the Fed time to wait for additional employment and workforce gains, which have so far disappointed despite growth rates not seen in decades.

"I'm on the side of the debate that thinks the current uptick in inflation is transitory," said Laurence Ball, former visiting scholar at the Fed Board and the Boston Fed. Ball said he's a "big believer" in measuring core inflation with the Cleveland Fed's weighted median inflation rate, which he noted has been quite stable at just over 2% for CPI.

"It filters out the effects of big increases in sectors such as used cars, airfares, and lodging," he said. "Inflation expectations are strongly anchored, so inflation will naturally return to the Fed's target without drastic action by the Fed."

Wilcox offered a similar view. "We don't have evidence yet that longer-term inflation expectations have moved above where they were in 2014 and 2015. It's reasonable to draw a conclusion that inflation expectations remain at levels broadly consistent with the Fed's 2% objective."

UNCERTAINTY BAND

This doesn't mean inflation concerns are gone for good. The ex-staffers emphasized uncertainty as the economy emerges from the Covid slump, whereas others have previously told MNI the Fed should change its policy stance or risk higher inflation expectations becoming entrenched.

Key factors remain to be determined in coming months. In last week's testimony Powell pointed to questions over the portion of recent retirements which turns out to be permanent, and to the extent that a shortage of childcare options proves an impediment to workforce participation.

"It is too early to tell, as the expected demand and prices have surpassed all expectations, whether this trend will continue or not," said Marcelle Chauvet, former senior research economist and policy adviser at the Atlanta Fed.

"There are lots of adjustments going on in the labor markets, commodity markets, manufacturing industries – most of these adjustments are temporary, but there is a fraction that will be of a more permanent nature."

Expectations are high for a surge in workforce participation when schools reopen fully in the fall, although the Delta Covid variant is prompting fears of continuing disruption, particularly in regions with low vaccination rates.

The Fed's initial hopes for 1-million plus job gains have been curtailed to expectations of about a half a million per month. The Fed wants significant gains in the employment to population ratio before declaring substantial further progress has been achieved in the labor market, its criteria for paring back QE.

Sahm thinks the Fed could wait until as late as March 2022 to reduce bond buying, though market expectations center around an announcement later this year.

"The calendar is not working in favor of tapering by the end of the year," Sahm said.