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Federal Reserve Chair Jerome Powell is under pressure from investors to square the central bank’s new inflation concerns with its ten-month-old commitment to seek broad and inclusive gains in the labor market.
The Fed’s meeting last week ignited confusion about its new approach toward keeping price increases in check and job growth going. Policy makers including New York Fed President John Williams and Boston Fed chief Eric Rosengren are among the numerous officials speaking this week who may provide more clarity after St. Louis’s James Bullard said last week interest-rates may need to rise in 2022.
Powell himself may face inquiries when he appears before U.S. lawmakers on Tuesday to give them an update on the Fed’s support for the economy through the pandemic.
Fearing Inflation
Fed policy makers are increasingly concerned that prices will rise more
Source: Federal Reserve Summary of Economic Projections
In the background as Powell speaks: Whether President Joe Biden will offer him a second term when his current tenure as chair expires in February, plus the sharp swings in financial markets after policy makers surprised investors on Wednesday by signaling they were gearing up to begin removing emergency support for the recovery.
Here are some of the questions swirling in the markets, which by Friday’s close had left the Dow Jones Industrial Average 3.5% lower over the week.
Dot-Plot Shock
Investors were taken unawares by the heightened concern about inflation risks that Fed officials revealed through their updated quarterly forecasts. These included two rate increases in 2023, according to the median projection in their dot-plot display of estimates, compared to none when they submitted them in March.
While their projections for inflation are still modest -- a bit above 2% in 2022 and 2023 -- they moved up over the next three years, signaling more persistent pressures. Policy makers answered that risk with a faster pace of rate hikes: Seven of 18 penciled in lift off in 2022, up from four in March. Thirteen saw at least one hike by the end of 2023, versus seven.
”The reaction to the inflation data was what surprised us,” said Brett Ryan, senior economist at Deutsche Bank Securities. “This was Powell acknowledging that we want to be a little bit more balanced in our inflation communication instead of just blankly dismissing everything as transitory.”
Bond markets responded with falling long-term Treasury yields and a rise in short-term yields, as a faster pace of tightening was priced in. It’s the kind of outcome a central banker would want to see in a time of rising prices and public inflation expectations.
Read More: Treasury Flattening Accelerates, Taking 30-Year to Cusp of 2%
Fed’s New Framework
The Fed meeting last week may also have revealed a policy preference within the new framework it adopted in August to ensure inflation expectations remain well anchored.
Going into the meeting, surveys showed public inflation expectations running higher. The New York Fed’s household survey showed three-year-ahead inflation rising to 3.6%, the highest since 2013. U.S. central bankers forecast inflation rising 3.4% this year and then easing to 2.1% and 2.2% for the next two years.
“If consumers continue to anticipate inflation near 3% over the next several years, the actual inflation rate is going to be well above 2%,” Andrew Levin, an economics professor at Dartmouth College, told other Fed watchers Friday.
To hit the Fed’s projection, inflation in the second half of the year has to be below what it was in the first half. “But it seems more likely that inflation will run well above the Fed’s target over the next several years, ” Levin said.
Powell is optimistic that bottlenecks in supply as the economy reopens -- viewed as part of the reason why inflation ran high in April and May -- will be resolved in coming months.
But officials also took out some insurance in case that optimism proves wrong by showing markets -- via their dot plot -- that they will respond to inflation risks with higher rates. Those projections influence expectations as well.
“It’s fundamental in our framework, our new framework, to assure that longer-term inflation expectations are anchored at a place that is consistent with our goal,” Powell said at his post-meeting press conference.
On Jobs
The Fed’s defensive posture on inflation also raised questions about its optimistic forecasts for full employment.
The central bank’s statement on its longer-run strategy says maximum employment is a “a broad-based and inclusive goal” meaning it will be measured against a much bigger group of indicators, such as participation rates -- which have declined more for women than men -- and Black unemployment which stood at 9.1% in May.
Central bankers’ projections also showed the economy converging on pre-pandemic lows of unemployment of 3.5% in 2023, but that could prove hard to achieve with millions of Americans still out of work.
“The low hanging fruit has already been picked and we are now experiencing the frictions of rehiring millions of people,” said Constance Hunter, chief economist at KPMG LLP.
Fed policy can do little to speed up vaccination rates or relocate people whose jobs have been taken by technology or consolidation during the pandemic. If faced with rising inflation risks or structural problems in the labor market, the Fed is going to lean against higher inflation so it can maintain moderate borrowing costs and keep the recovery on track, she said.
“They are not going risk credibility on inflation,” said Hunter, though they may be able to deliver both stable prices and maximum employment if they maintain “their exceptional credibility.”
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