Jerome Powell spent several months during 2021 claiming that the rise in inflation was "transitory," justifying the sharp increase in the Federal Reserve's balance sheet. Repeated statements in SriKonomics writeups (for example, here) that the Chairman was wrong in his assessment did little to persuade him or his colleagues to tighten last year.
The new mantra this year became that the Fed would start to raise rates and reduce assets, but that inflation reduction would be achieved without increasing the unemployment rate or slowing the pace of economic growth significantly. The Fed forecast on March 16 after its two-day meeting that the unemployment rate would remain unchanged at 3.5% in 2022 and 2023 despite the tightening. The economy would continue to grow by 2.8% this year, slowing to only 2.2% next year. What a pain-free way to implement tighter monetary policy!
But all that changed last week. The US Bureau of Labor Statistics announced Wednesday that consumer prices had risen by 8.3% last month compared with April 2021. While this was slightly slower than the 40-year high of 8.5% recorded in March, it was still too elevated for comfort. Especially galling for the Biden administration and the Federal Reserve, the month-on-month change in core prices (that exclude food and energy) had accelerated from 0.3% in March to 0.6% in April. Overall, inflation had moved from goods to services, and had spread to the broader consumer basket rather than be confined just to items affected by the supply bottlenecks.
At a press conference, President Joe Biden blamed the high inflation on price gouging by US firms in critical sectors, the continuing impact of covid-related bottlenecks, and the Russian invasion of Ukraine. Notably missing from the President's list of factors were the Fed's doubling of its balance sheet since covid, and his administration's $1.9 trillion fiscal stimulus last year which added to the $900 billion spent in the final months of the Trump administration.
Publication of data on the producer price index on Thursday did little to assuage concerns about inflation. The figures showed that headline PPI rose by 11% in April over the previous year, only slightly slower than the 11.5% in March. Although a surge in natural gas prices accounted for a significant portion of the overall increase, the wholesale price of eggs, coal, grains and raw cotton also jumped. Increases in PPI tend to be reflected in the consumer price index with a lag.
Powell's major shift toward hawkishness also came on Thursday. Less than two months after his press conference on March 16 when he suggested that he could achieve inflation reduction without pain, he admitted in an interview with Marketplace that whether or not there would be a soft landing of the economy "may actually depend on factors that we don't control."
He also distanced himself from his statement at the press conference May 4 where he had dismissed the idea of a 75 basis point hike. Powell indicated in the Marketplace interview that if incoming data "come in worse than when we expect," a 75bp increase would be in the cards.
Translation: The Fed's efforts to bring down inflation to its 2% target could involve a recession with much higher unemployment rates.
What prompted the abrupt pivot toward hawkishness? Just hours before the Powell interview, the Senate confirmed him by an 80 -19 vote for another four-year term. I had anticipated in my note of April 30 that an acknowledgment by Powell that Fed tightening would have painful consequences for the general population would come only after he was confirmed by the Senate. But even I was surprised by the speed of the shift!
Expect the twists and turns in the soap opera, aka Fed policy, to persist. That is why the recent interview Professor John Taylor of Stanford University gave to Bloomberg TV's Michael Mckee about instituting the Taylor Rule is timely. Taylor points out it is important for the Fed to signal where it is headed, with the Rule allowing for the policy to change if inflation comes in lower or higher than targeted. No uncertainty on that front for investors. He also suggests that the current high inflation rate would call for the Federal Funds rate in the neighborhood of 4%.
It is unlikely that the Fed will heed such advice. But investors would benefit from a move away from the ongoing seat-of-the-pants decision making made up of abrupt swerves in policy.
Dr. Komal Sri-Kumar
Sri-Kumar Global Strategies, Inc.
Santa Monica, California