The Fed is on a long journey to reality. For months it was in denial that inflation would rise. It then tamed market fears with strong spin that inflation would rise – but would subside shortly after.
The central bank assured many that the inflation would be temporary. They conceded some things would be scarce whilst supply caught up as restrictions were eased. It was just a case of friction and delay in reopening and getting up to full working after the closures.
If you read the official Federal Reserve Open Markets Committee (FOMC) statement issued on 16 June nothing has changed. The vast money creation of $120bn a month goes on. Interest rates stay very low, and the government carries on with huge borrowing at ultra-low rates.
We are assured the Fed is not financing the government. It is a happy coincidence that the Fed prints billions of dollars and buys billions of second-hand bonds at very low interest rates – at the same time that the government wants to borrow massive sums on the cheap.
Making up for weaker times
The Fed Chairman, Jerome Powell, and the Treasury Secretary, Janet Yellen, are as one in thinking the economy should be allowed to run “hotter for longer”. They think inflation will then subside. They want inflation to be a little above 2% after a period when it was below this target to get the average up.
So far, markets have accepted this view and enjoyed the upwards ride, buoyed by all the dollars the Fed is printing. The Fed itself underpins bond values. The equity market gets a boost by comparing equity values to relatively-expensive bonds.
This week, the first brick in this defensive wall was pulled out. Jerome Powell lost control of his FOMC and allowed them to start to move the debate on. Whilst they formally agreed no change of policy or language, collectively they raised their inflation estimate by a whole percentage point, to 3.4%, a 40% inflationary surge in their forecast. They also decided that there are likely to be two rate rises in 2023, a whole year earlier than their previous forecasts.
Its Chairman tried to reassure that this rate rise forecast did not mean it would happen. He stressed the Committee has not made any such formal decision. Mr Powell’s Committee members are trying to tell him something. They are shifting their views as events and market pressures are beginning to get to them. The Chairman needs to keep them onside for future discussions and votes.
Demand vs supply
Through all this the Fed sticks to its analysis, which sees everything in supply terms. There is more inflation because more things have supply shortages. The shortages will go away as people will put in more semiconductor factories, more energy capacity, more copper and lithium mines. Maybe after the summer more people will make themselves available for jobs to keep wages under control.
They never ponder the possibility that there is too much demand. If government and the people want to spend all those dollars in a hurry that they have created and borrowed, there will indeed be acute supply shortages and more price rises.
Attention needs to shift to the commercial banks as well as to the Fed. The Fed’s actions have created balance-sheet scope and liquidity for the commercial banks to lend more. If this added to consumers with money on deposit running down some savings and spending more, things could get quite lively. Janet Yellen and Jerome Powell have a lot of power and will continue to defend their narrative that running hot is fine and inflation is temporary. Even they cannot suspend one of the oldest beliefs of economics, that if too much money chases too few goods the price of goods goes up.
In the weeks ahead, members of the FOMC will come under increasing pressure to take inflation seriously. The first thing they will have to do is to announce a timely and tapered end to quantitative easing. It is not just members of the committee that are wandering. More investment houses are now questioning how limited and temporary the price rises will be.
Our base case assumes the Fed judges things well, keeps control of the narrative and does just enough to taper in time. If they do not, the markets could turn on them to force it. We need to watch out for more hostile data, and for Fed members themselves changing their minds clumsily. They need to boss markets convincingly as the price rises come through.
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The Fed's view of inflation is changing
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