Threading the needle Threading the needle\images\insights\article\needle-thread-small.jpg November 12 2021 November 12 2021

Threading the needle

With inflation soaring and tapering starting, President Biden's choices for Fed seats are crucial.

Published November 12 2021
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Inflationary pressures are soaring at their fastest pace in more than three decades, with no end in sight. Over the past six months, the Federal Reserve has been losing the semantical tug-of-war between “transitory” and “sustainable,” and the central bank officially threw in the towel last week. At the conclusion of the Nov. 3 FOMC meeting, the Fed announced the imminent start of a tapering schedule that will reduce monthly bond purchases from $120 billion to zero over perhaps the next eight months. We expect interest-rate hikes to start in the second half of 2022.

But in our view, the financial markets are underappreciating an important leadership transition issue that looms over the Fed at this critical inflection point. The terms of Fed Chair Jerome Powell and Vice Chair Richard Clarida both expire next January, and Vice Chair for Banking Supervision Randy Quarles announced that he will leave the Board of Governors at year-end. There’s already an open seat on the seven-member Board of Governors, as the Senate failed to confirm Trump nominee Judy Shelton last year. 

President Biden likely will make four nominations to the Fed Board in coming weeks, with an eye toward satisfying two conflicting constituencies. On the one hand, Wall Street hates uncertainty and prizes consistency, particularly with the Fed chair. But Biden’s progressive base wants greater diversity on the board. They would like to see more emphasis on issues such as climate change, banking regulation and racial disparities, even if they come at the expense of the Fed’s traditional Phillips’ curve trade-off between moderate inflation and full employment. 

“Procedural base effects” in the rear-view mirror Inflation has surged over the past several quarters, even though we’ve lapped the negative readings we experienced at the depth of the pandemic from February through May 2020.

  • Producer Price Index (PPI) Nominal wholesale inflation soared 8.6% year-over-year (y/y) in September and October 2021, a 10-year high. Core inflation (which strips out food, energy and trade) rose 6.2% y/y in October, just under August’s 7-year high of 6.3%.
  • Consumer Price Index (CPI) Nominal retail inflation leapt 6.2% y/y in October 2021, a 31-year high. Core inflation (which excludes food and energy) surged to a 30-year high of 4.6% y/y last month.
  • Personal Consumption Expenditures (PCE) The core PCE index (the Fed’s preferred measure of inflation) hit a 30-year high of 3.6% y/y in each of June, July, August and September—well above the Fed’s 2% target.

Retail inflation in October was paced by outsized gains in energy, autos, food and furniture, none of which appear poised to reverse in coming months. Due to a series of policy decisions in Washington, natural gas prices have more than tripled over the past year, crude oil has risen 150% and retail gasoline prices have increased more than 60%. New-car prices rose nearly 10% in October month-over-month (m/m), the largest gain since 1975. Restaurant prices increased by more than 5% last month, the sharpest increase since 1982. Finally, prices for furniture and bedding rose 12-13% m/m, the most since 1951.

Self-perpetuating cycle Driven by the tight labor market, average hourly earnings have risen 5.8% y/y over the past seven months through October, and companies are simply passing those higher labor costs onto end customers in the form of higher prices. This is creating a self-perpetuating wage-price cycle, as workers are demanding higher wages to compensate for the sustainable spike in inflation.

According to the Wall Street Journal, real wages (nominal wage gains adjusted for inflation) are down 2.2% since January, American purchasing power has declined, and the average standard of living has fallen, despite record levels of fiscal-policy stimulus.

Fed shifts policy gears Tapering the $120 billion monthly bond-buying program will reduce proportionately its Treasury and mortgage-backed purchases by $10 billion and $5 billion per month, respectively. Although policymakers have left themselves some wiggle room to re-evaluate that pace in coming months, they could complete the process by June 2022, which could set the stage for their first hike in interest rates in the second half of 2022. We expect one or two rate hikes next year, with perhaps three or four more quarter-point hikes during 2023.

Fed leadership transition looms At this critical inflection point for surging inflation and the Fed’s pending withdrawal of monetary policy accommodation, the financial markets are anxiously awaiting Biden’s decision on how he plans to remake the Fed’s Board of Governors.  Typically, presidents announce their picks to lead the Fed between August and October, allowing the Senate enough time to conduct its due diligence ahead of a confirmation vote. But we’re rapidly running out of time, as the Senate will likely take some vacation time during the Thanksgiving and Christmas holidays.

Sen. Elizabeth Warren (D-MA) set the stage for a potentially contentious confirmation hearing, when she publicly rebuked Chair Powell in September, calling him “dangerous” and vowing to oppose his re-nomination over perceived lapses in regulatory oversight. On the merits, we continue to believe that Chair Powell deserves a second term, and Wall Street generally believes his reappointment by Biden will be a slam dunk. Financial markets hate uncertainty, of course, so an unexpected change in central bank leadership could unsettle them.

The problem, in our view, is that, while Congressional moderates and conservatives agree Powell deserves a second term, liberals and progressives (like Sen. Warren) are lobbying against it. They believe that Powell has been too loose with financial regulations on the banking industry and has not advocated forcefully enough for their progressive priorities, such as climate change and racial and economic justice.

Throw both sides a bone We expect Biden to re-nominate Powell, in the hopes of quelling a financial-market uproar. He has been hemorrhaging political capital in recent months, with sharply declining poll numbers, due to the surge in the Covid-19 delta variant in July and August, an 85% decline in vaccination rates since April, his bungling of the troop withdrawal in Afghanistan, the ongoing southern border crisis and the spike in sustainable inflation and energy prices, among other issues. But we think he will select from a list of a dozen or so progressive candidates to fill the three open board seats, lending the Fed a leftward tilt to satisfy his progressive base.

Brainard gets a promotion? If Biden decides not to re-nominate Powell, current Fed Governor Lael Brainard likely would be his choice to be the next Fed Chair. But if Powell gets re-appointed, then Brainard probably still will be promoted to Clarida’s soon-to-be-vacant vice-chair seat or Quarles’ vacant vice-chair for banking supervision role. To fill out the remaining three open seats, Biden might choose from among William Spriggs, Lisa Cook, Sarah Bloom-Raskin, Seth Carpenter and Karen Dynan, among other candidates. 

Market risk? Once confirmed by the Senate, the market will need to evaluate the collective package of Biden’s new Fed governors with an important question in mind. Given the surge in sustainable inflation, will the new board follow through on the old Fed’s policy decision to taper bond-buying now and eventually raise interest rates? Or will they allow the Fed to get further behind the inflation curve, which may require a potentially more draconian Volker-esque policy response somewhere down the road, to get the raging inflation genie back in the bottle?

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Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Consumer Price Index (CPI): A measure of inflation at the retail level.

Personal Consumption Expenditure (PCE) Index: A measure of inflation at the consumer level.

Producer Price Index (PPI): A measure of inflation at the wholesale level.

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