• A predominant buzzword for 2021, “transitory” may need to be retired as a description of inflation risks according to Fed Chair Jerome Powell
  • A demand shock from trillions in fiscal and monetary stimulus continues to overwhelm supply, causing more dovish leaders at the Fed to reconsider prior plans to leave the fed funds rate unchanged in 2022
  • Detection of the Omicron variant was another reminder that Covid remains a stubborn risk to global growth and inflation expectations nearly 2 years after the start of the pandemic

If there was a ranking of economic buzzwords for 2021, the term ‘transitory’ would have to be near the top of the list. This word has been used over and over by Fed Chair Jerome Powell and his colleagues to describe inflation pressures emerging from the reopening of the global economy. However, inflation rates, even after excluding food and energy prices, have remained stubbornly elevated near multi-decade highs, making inflation a hot topic in mainstream media and politics. The latter has shined an even brighter light on Powell, who was at the same time vying for a second term as Fed chair. Competing with Powell for the top job was Fed Governor Lael Brainard, who was generally perceived to be more dovish of the two (a very relative comparison). Given the heightened public focus on rising consumer prices, the dovishness was likely a notable factor in the White House’s decision to announce on November 22 that Powell would indeed get the nod for a second term. The bond market responded to the news by pricing for more hawkish policy in the near/intermediate term.

On November 30, in his first major appearance since the nomination announcement, Powell caught markets off guard with a definitive shift in tone regarding inflation risks. Testifying before the Senate Banking Committee, Powell effectively extinguished the transitory inflation assessment. When pressed on the topic, Powell said, “I think it’s probably a good time to retire that word and try to explain more clearly what we mean.” In other words, the price increases of the last several months may indeed be more permanent than the Fed had been anticipating, and as such, a more hawkish policy response may be necessary. To that end, Powell also noted potential policy changes to combat non-transitory price pressures, specifically the pace of asset purchase tapering. “At this point, the economy is very strong and inflationary pressures are higher, and it is therefore appropriate in my view to consider wrapping up the taper of our asset purchases…perhaps a few months sooner,” he said. At the November 3 FOMC meeting, the Fed announced, as expected, a tapering pace of $15 billion per month, which would imply no new purchases (other than principal reinvestment) by the end of Q2. Shortening the pace by three months would increase monthly tapering by approximately $10 billion (~$25 billion total).

Perfect Inflation Storm Exhibit 1 illustrates the surge in core inflation that has occurred this year, pushing both CPI and PCE to the highest levels since the early 1990s. In 2020, the Fed shifted to a new policy framework that called for flexible average inflation targeting (FAIT), which would theoretically allow inflation to run above the 2% target for “some time” to offset prior periods of below-target inflation and effectively reset inflation expectations. Central bankers at the Fed and overseas are feeling the pressure to respond to these inflation pressures, and while not the first action (tapering already announced), Powell ditching the “transitory” characterization is a clear change in tone/guidance.

Supply shortages have undoubtedly fueled price pressures, and this supply/demand imbalance has persisted longer than many economists expected. It is always important to note that shortages are always relative to demand. In other words, supply chain disruptions can be alleviated over time, but if supply still lags demand, prices will move higher.

What we experienced in the Covid crisis was an unprecedented demand shock. Trillions of dollars in monetary and fiscal stimulus from major developed economies more than compensated for lost income during lockdowns, but the supply of goods and services that those incomes had been providing was left untouched. In other words, if I pay you to stay at home, you’re staying at home buying the products that you’re not at work producing. At the same time, income that may have normally been spent on services (restaurants, travel, etc.) shifted to goods, putting more pressure on supply chains still inhibited by labor shortages and Covid protocols. It’s a perfect storm for the inflation that we have experienced.

The impact of massive stimulus should eventually fade, and demand for goods and services should eventually realign with supply. Timing is everything, though, and there’s only so long that central bankers can idly stand by while inflation runs more than double the target rate. 2022 will certainly test Fed leaders on that front.

Covid Remains a Risk

Approaching the 2-year anniversary of the pandemic, we were reminded again in late November that Covid remains a stubborn risk to the global economy. Detection of the newest variant (Omicron) sparked a global risk-off trade the day after Thanksgiving that sent U.S. equities down more than 2% and term Treasury yields down 14-18 basis points (bps). To be fair, the reaction in financial markets was exacerbated by poor liquidity on the day after a major holiday, and at this point, there appears to be very little political will to mandate activity restrictions in response to increased infection rates. Nevertheless, continued flare ups of the virus can certainly impact global travel, manufacturing, and shipping. As such, the virus remains a risk to economic growth and inflation, and it’s a scenario like this that brings words like “stagflation” into the conversation.

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