Adding Fed Fears to Inflation Worries


ECONOMY AND POLICY January 28, 2022

Chief Economist Scott Brown discusses current economic conditions.

As expected, the Federal Open Market Committee left short-term interest rates unchanged, but strongly signaled that a hike will be coming in March. However, Chair Powell’s comments during his press conference caught investors’ attention. Asked about the timing and pace of interest rate hikes, Powell could not rule out raising rates more aggressively if needed. That’s just common sense, of course, but the markets were anticipating a gradual pace of rate hikes. The Fed doesn’t know the path that monetary policy will take in the months ahead. That will depend on the incoming information on the economy. So, what should investors do? Relying on any particular outlook for the economy or Fed policy is folly. Investors should be flexible and have a plan because (as we’ve seen in recent weeks) conditions can change.


In its January 26 policy statement, the FOMC wrote that it “expects it will soon be appropriate to raise the target range for the federal funds rate.” That means a March 16 rate hike is all but certain. In his post-FOMC press conference, Powell recognized that “inflation remains well above our longer-term goal of 2%.” Supply and demand imbalances related to the pandemic and reopening of the economy have contributed to higher inflation. Bottlenecks and supply constraints limit how quickly production can respond to higher production in the near term – and these problems have been “larger and longer-lasting than anticipated, exacerbated by waves of the virus.” More troublesome, “price increases have now spread to a broader range of goods and services.” Wages have risen briskly. The Fed, like most forecasters, expects inflation to decline, but “we are attentive to the risks that real wage growth in excess of productivity growth could put upward pressure on inflation” and the Fed will act to prevent higher inflation from becoming entrenched.


Powell noted that most FOMC participants agree that labor market conditions are consistent with maximum employment (in the sense of the highest level of employment that is consistent with price stability). “By so many measures, this is a historically tight labor market – record levels of the job opening, or quits.” Clearly, “the economy no longer needs sustained high levels of monetary policy support.” Powell emphasized that “the economic outlook remains highly uncertain.” Recognizing that “the economy evolves in unexpected ways,” making appropriate monetary policy “requires humility.” Fed policymakers “will need to be nimble so that we can respond to the full range of plausible outcomes.”


Asked about whether the Fed intends to raise rates at every other meeting (the market consensus view heading into the press conference), as opposed to every policy meeting (as in past tightening cycles), Powell said that “it is not possible to predict with much confidence exactly what path for our policy is going to prove appropriate.” The Fed has not made any decisions on that. However, he noted that in comparison to the start of rate increases in 2015, “the economy is now much stronger, the labor market is far stronger, and inflation is running well above our 2% target – and these differences are likely to have important implications for the appropriate pace of policy adjustments.”


The FOMC further slowed the monthly pace of asset purchases and reaffirmed that these will end in March, but did not signal the possible timing of balance sheet reduction. It did, however, lay out some principles for the future: 1) the federal funds rate will remain the main tool for adjusting monetary policy; 2) balance sheet reduction will occur after the rise in interest rates; 3) reductions will occur in a predictable manner primarily through adjustments to reinvestments (so securities roll-off over time); 4) the size of the balance sheet should ultimately be consistent with the Fed’s ample reserves operating framework; 5) the Fed expected to hold Treasuries (phasing out its holdings of mortgage-backed securities). The FOMC “has not made decisions regarding the specific timing, pace, or other details of shrinking the balance sheet.” These matters will be discussed at future policy meetings.


Real GDP rose at a 6.9% annual rate in the advance estimate for 4Q21, but a large chunk of that (4.9 percentage points) was a shift from inventory reduction to inventory accumulation. Inflation-adjusted consumer spending rose at a 3.3% annual rate, partly reflecting a rebound from the Delta wave, but spending fell 1.0% in December. Business fixed investment rose at a 2.0% pace, but was mixed (structures -11.4%, equipment +0.8, intellectual property products +10.6%). The economy appears to be normalizing (granted, toward a new normal), so monetary policy should be a lot closer to neutral. Getting there presents some challenges. For example, we saw in the last tightening cycle that housing is very sensitive to long-term interest rates. Raising borrowing costs helps savers, but also hurts those at the lower end of the income scale, who are generally suffering more from higher inflation. Uncertainty isn’t good for investors, but whatever path the Fed ends up on won’t be an easy one.


Recent Economic Data


Real GDP rose at a 6.9% annual rate in the advance estimate for 4Q21, reflecting a large turn in inventories (which added 4.9 percentage points to the headline growth figure. Consumer spending rose at a 3.3% annual rate. Business fixed investment rose 2.0% but was mixed across sectors. Imports (which have a negative sign in the GDP calculation) and exports rose sharply, offsetting each other.



Personal income rose 0.3% in December (+7.3% y/y), with private-sector wages and salaries up 0.8% (+10.0% y/y). Personal spending fell 0.6% (+13.3% y/y). Adjusted for inflation, disposable income fell 0.2% (-0.2% y/y), while spending fell 1.0% (+7.1% y/y).


The PCE Price Index (the Fed’s main inflation gauge) rose 0.4% in December (+5.8% y/y), up 0.5% (+4.9% y/y) ex-food & energy. The Dallas Fed’s Trimmed-Mean PCE Price Index rose 0.3% (+3.0% y/y), consistent with a broadening of price increases (although not as severe as in the Trimmed-Mean CPI).



The Employment Cost Index, the preferred measure of labor costs, rose 1.0% in the three months ending in December, up 4.0% y/y (vs. +2.5% in 2020).


The Conference Board’s Consumer Confidence Index slipped to 113.8 in the initial estimate for January, down from 115.2 in December. Evaluation of the present situation improved (148.2, vs. 144.8), while expectations weakened (90.8, vs. 95.4). Current labor market perceptions remained optimistic.


In an update to its World Economic Outlook, the IMF lowered its global growth outlook for 2022 to +4.4% (vs. a forecast of +4.9% made in October).


The Chicago Fed National Activity Index, a composite of 85 economic indicators, fell to -0.15 in December, vs. 0.44 in November. The three-month average was 0.33, consistent with above-trend growth.



Durable goods orders fell 0.9% in December, reflecting a decline in aircraft orders (civilian down 14.4%, defense down 11.2%). Ex-transportation, orders rose 0.4%, mixed across industries. Orders for nondefense capital goods ex-aircraft were unchanged, while shipments rose 1.3%.


New home sales rose 11.9% (±20.3%) in December, to an 811,000 seasonally adjusted annual rate.


Jobless claims fell by 30,000 in the week ending January 22, to 260,000 (vs. a 204,000 average for December). Seasonal adjustment is always suspect in January (unadjusted claims normally spike at the start of the year), but the increase likely reflects an impact from the Omicron variant.



The Chicago Fed Advance Retail Trade Sales (CARTS) data estimated a 1.1% increase over the first two weeks of January, with ex-auto sales tracking at a 0.4% rise (for the whole month) relative to December.


The UM Consumer Sentiment Index fell to 67.2 in the full-month reading for January, down from 68.8 at mid-month and 70.6 in December reflecting inflation worries. The survey ran from December 27 to January 24.


The opinions offered by Dr. Brown are provided as of the date above and are subject to change. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.


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