Is the Fed blinded by data?
Once dubbed ‘transitory’, the Fed’s aggressive action on inflation lacks consideration for supply-side issues.
On March 16, 2022, the US Federal Reserve Bank’s Federal Open Market Committee hiked its policy rate by 25bp to 0.50%, the first policy rate action since the 1.00% cut from 1.25% to 0.25% on March 16, 2020. In Addition, the Fed’s economic projections suggest seven rate hikes in 2022 and five in 2023 (chart 1).
Chart 1. Fed’s Projected appropriate policy rate path compared with prior projections
Chart 2. Detailed view of Fed’s policy rate projections compared with prior projections
Chart 3. Net Change in the Fed’s Projected appropriate policy rate path March vs. December projections
Earlier this month, President Biden mentioned inflation six times in his State of the Union addressed on March 1, 2022. With all the world’s problems and the US in particular, Mr. Biden said, “Inflation is robbing them (American families) of the gains they might otherwise feel. I get it. That’s why my top priority is getting prices under control.” Furthermore, he further said, “So what are we waiting for? Let’s get this done. And while you’re at it, confirm my nominees to the Federal Reserve, which plays a critical role in fighting inflation.”1
In the Fed’s FOMC statement released March 16, 2022, inflation is also mentioned six times — interesting fact, coincidence?
Even more interesting is that the Fed’s statement states, “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” We agree, and we never subscribed to the idea that inflation is transitory. We believed while some factors contributing to higher inflation were transitory, most were not. While the Fed is correct that inflation stems from supply and demand imbalances, it is vital to determine the more significant variable, supply or demand? In our view, much of the price pressures are due to supply-side issues, which will take time to correct, and thus the solution to such strong price pressures is a mix of policies tools, including trade, fiscal and monetary.
Additionally, on January 28, 2022, the Federal Reserve Bank of New York’s Liberty Street Economics team released a paper, The Global Supply Side Inflationary Pressures2, which confirmed our thesis; “Our main finding is that global supply factors are very strongly associated with recent producer price index (PPI) inflation across countries, as well as with consumer price index (CPI) goods inflation, both historically and during the recent bout of inflation acceleration.”4 Therefore, we were of the view that the Fed will adjust policy slowly, more than what it signaled yesterday.
On labor market conditions, during his press conference, Powell described the labor market as being “extremely tight.” While some of the job creation seen over the past couple of quarters is likely due to the reopening of the economy, job creation has also jumped due to policies stemming from the economic security is national security initiatives introduced by the Trump administration in 2018”3, America is safer when important technology and essential products are produced domestically.”
The reopening of the economy, fiscal policy in general and fiscal policies linked to economic security coupled and in addition to the recent acceleration in reshoring due to geopolitical issues, supply chain concerns, rising offshore wages, immigration laws, concerns about product quality, among other factors has helped to ignite the job market. Bringing jobs “back home” and reinvesting, rebuilding, was it not what Trump and the Biden team wanted, to build back areas of the economy deemed to be of strategic importance? Will the Fed’s projected seven rate hikes derail Washington D.C.’s plan?
We believe the projected policy path released yesterday is too aggressive, especially considering the GDP change projections show GDP generally anchored at 2%. Was is not inflation that is supposed to be anchored somewhat around 2% in the medium term within the AIT framework?
Our key takeaway from yesterday’s Fed decision, statement4, projections, and press conference is that a complex adaptive system such as the US economy requires a more holistic analysis. Such a data-centric Fed seems to continue not to see the economy through the forest of data.
Chart 4, 5 – Fed’s GDP and PCE Inflation projections
1. State of the Union Address as Prepared for Delivery, March 01 2022. (Regarding Mr. Biden’s mention, “And while you’re at it, confirm my nominees to the Federal Reserve, which plays a critical role in fighting inflation,” he is refereeing to the fact that there are three out of the seven federal reserve board seats vacant. It is also important to remember that Fed Chair Powell has been an interim chair since his renomination to a second term by Mr. Biden on November 21, 2022, is awaiting Senate confirmation. On February 4, 2022, the Federal Reserve Board named Jerome H. Powell as Chair Pro Tempore, pending Senate confirmation to a second term as Chair of the Board of Governors.)
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