Powell calm despite inflation storm
The Chair's trip to Capitol Hill showed just how patient the Fed intends to be.
The inflation debate rages on. Price pressures were on full display this week with the release of CPI and PPI for the month of June. What wasn’t so clear, however, was whether they will meet the Federal Reserve’s definition of inflation. We should be careful not to attach too much significance to the year-over-year measures of price data because they still fall under base effects from sharp price declines 12 months ago. But the month-to-month data is telling. The 0.9% change in CPI was well above expectations, powered by an astounding 10.5% rise in used car prices and additional pressures in airfares, lodging and restaurant meals.
Yet in most policymakers’ minds, these types of increases are a product of surging demand as the economy reopened with more force than expected, against constrained supply as supply chains impacted by the pandemic couldn’t adapt as quickly. It’s a dynamic they think should eventually ease and that logic makes sense to me. Eventually greater supply, ebbing demand and shifts in consumer behavior will begin to take the edge off. There are stickier components of the CPI release, however, that don’t seem to fall into that same category. Most notably, owners’ equivalent rent, which rose by 0.32% for the month. It likely did not escape the Fed’s attention even if officials don’t say it out loud.
Chair Powell seemed pretty unbothered by it all during his appearances on Capitol Hill this week. He acknowledged the increases had exceeded the Fed’s own expectations, but still believes that much of the pressure will subside. We even got some sense of how patient the Fed could be. He defined inflation as, “Year after year after year, prices go up”, and left the impression that it could take six months before the Fed would conclude that what it suspects is transitory might actually be more structural in nature.
Is this wait-and-see approach wrong? Is it risking 70s style inflation? I don’t think so. While there surely will be more structural inflation in some sectors when the dust all settles, we may be seeing the peak in prices for some areas that have been supply constrained. And, of course, the Fed also has a full employment mandate. While how the Fed measures that in the post-pandemic world is not entirely known (perhaps even by the policy-setting Federal Open Market Committee), it’s not at the level at which we are today.
If substantial progress is made toward full employment over the next six months as supplemental unemployment benefits end and schools return to in person attendance, the Fed will be willing to start to remove policy accommodation even if the verdict on the permanence of inflation is not yet in. I think many officials are no longer comfortable with the current pace of asset purchases as they have not been needed for the purpose of supporting market functioning for quite some time. So in the fourth quarter, we expect them to outline their taper plans, which should include both Treasuries and agency mortgage-backed securities.