Will current Fed policy lead to inflation?

From

Steve Miller

Various key Fed spokespeople, including Chair Powell, Vice Chair Clarida and FOMC member Brainard, have all appeared to downplay nascent concerns that current Fed policy, combined with fiscal stimulus, may lead to the economy overheating and inflation.

In so doing Fed speakers appeared keen to emphasise that any talk of withdrawing stimulus is a long way off.

Inflation concerns/tapering

Any signs that the Fed is concerned about the potential re-emergence of inflation? Will that lead to tapering talk?

In testimony before the House Financial Services Committee, Federal Reserve Chair Jerome Powell emphasized his view that the economy has a long way to go in the recovery and signs of prices rising won’t necessarily lead to persistently high inflation. He emphasised that Fed policy “is accommodative because unemployment is high and the labour market is far from maximum employment”. In that testimony he seemed to insist that recent signs of inflation were temporary or down to base effects and were indicative of ongoing price rises. Those sorts of influences don’t “necessarily lead to inflation because inflation is a process that repeats itself year over year over year,” he said, rather than a one-time surge.

Earlier in the week Powell said that for some of the sectors that have been most adversely affected by the pandemic, prices remain particularly soft.

During his testimony, Powell voiced confidence that the Fed would ultimately succeed in lifting inflation and getting it to average 2% over time, but added that the task is potentially a long and drawn out one saying that “[w]e live in a time where there is significant disinflationary pressures around the world and where essentially all major advanced economy’s central banks have struggled to get to 2%.” Powell added that “it may take more than three years” to reach that goal.

His comments were reiterated elsewhere by Fed Vice Chair Clarida who expressed “cautious optimism” on the outlook but said it would “take some time” to restore the economy to pre-pandemic levels.

Fed Governor Lael Brainard warned that inflation remained “very low” and the economy was still far from the Fed’s goals.

Rising bond yields

Is the Fed concerned that there may be some sort of message in rising bond yields? Will rising bond yields potentially frustrate the Fed’s objectives in terms of employment and inflation?

At this point, the Fed seems to be charting a fine line of portraying the move up in yields as a natural consequence of an improving growth outlook and a statement on confidence of a robust and ultimately complete recovery in the offing on the one hand, while at the same time maintaining a dovish tilt emphasising that the economy is a long way from the Fed’s employment and inflation goals, and that it is likely to take some time for substantial further progress to be achieved. The Fed continues to suggest that QE will continue at its current pace until substantial further progress has been made toward their goals.

RBA and the rise in bond yields. Wage cost index data

In a slight difference of approach from the Fed, who doesn’t seem to be overly perturbed by the rise in bond yields, some press reports suggest that the RBA might seek to more aggressively defend its 3 year bond target currently at 0.10%. That might prove easier said than done if yields elsewhere keep rising unless the RBA wants to own the entirety of bonds on issue at that part of the curve. Arguably the RBA doesn’t need to be that aggressive. If yields are on the rise elsewhere then that will take pressure off the $A to appreciate and allow the RBA some ‘slippage’ in its target objective. The problem is that the magnitude of the move upwards in Australian bond yields is greater than that elsewhere.

Further tolerance of ‘slippage’ would be occasioned by upside surprises in wage data, as with yesterday’s release of wage cost index data for December. It is true that wage growth remains some way away from where the RBA would like to see it, and there were some compositional ‘quirks’ in yesterday’s numbers, but the data is another ‘straw in the wind’ that the economy has weathered the storm much better than had previously been thought and that, accordingly, previous (“best guess” rather than “pledge”) guidance from Governor Lowe may be revisited at some stage in the future. It is too early for that yet, despite yesterday’s upside surprise, wage growth remains moribund and the unemployment rate, again while having bettered expectations, is still some way north of the “4 point something” cited by the Governor as getting close to capacity. Indeed, the Governor explicitly cited wage growth in articulating his and the Board’s expectation of no increase in the cash rate before 2024, noting that “wages growth will have to be materially higher than it is currently” – still true after yesterday’s numbers. And “[t]his will require significant gains in employment and a return to a tight labour market”.

All said and done, I don’t think, therefore, that there is much doubt that there is a fair bit of anxiety up at Martin Place at the moment about the magnitude of the move in Australian bond yields over the last week or two compared to that which has taken place elsewhere.

As for next week’s RBA Board meeting, I don’t expect any new policy measures or changes to existing ones. I expect, however, that the tone of the Governor’s Statement will be very similar to February: an upbeat assessment of economic conditions but an aggressive statement that the RBA intends to maintain historically high levels of monetary accommodation. Despite slightly better than expected wage growth data, wage growth is still well short of where the RBA might wish it to be and the unemployment rate, again while having bettered expectations, is still some way north of the “4 point something” cited by the Governor as getting close to capacity. I expect the Governor to reiterate his and the Board’s expectation of no increase in the cash rate before 2024, and assert a strong desire for wages growth to be materially higher than it is currently and that this will require significant gains in employment and a return to a tight labour market.

For the RBA, with an eye firmly on the AUD, erring on the side of ‘too much’ rather than ‘too little’ is at this stage the least risky path.

RBNZ

The RBNZ, while welcoming the reasons behind rising bond yields, such as higher growth and inflation expectations, sought to remind the markets that if pricing went “too far” it might take action to push back on those developments and ease financial conditions further. In so doing Governor Orr sought to remind the market that it could still reduce the OCR further and sought further to underline that preparations for a negative cash rate are complete. The latter is a step of dubious utility, and implies another twist in RBNZ thinking on the efficacy of negative rates, but nevertheless Governor Orr presumably thought it a point worth making. Perhaps the bigger message the RBNZ sought to impart was that, despite some nascent market commentary to the contrary, it wasn’t even close to thinking about any tweaking of financial conditions firmer (some commentators had expected the RBNZ to start lifting rates from August 2022).

By Steve Miller, Adviser

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