The Fed Take On Inflation

On Wednesday, the Fed held its December meeting and adopted a significantly more aggressive posture to combating the inflation surge of 2021. The Fed is accelerating the wind down of its asset purchasing program so that it should conclude in March, which will then put the Fed in position to raise rates as necessary to try to curb inflation.

The Federal Open Market Committee also raised its inflation projections for 2021, which is not surprising since its September estimates were clearly outdated. Inflation expectations for 2021 are now 5.3% for all items (up from 4.2%), and 4.4% (up from 3.7%) excluding food and energy. The inflation outlook for 2022 is more sanguine, at 2.6% for headline inflation and 2.7% excluding food and energy. Unemployment projections have become more optimistic, with this month’s 2021 forecast coming in 4.3%, down from a 4.8% estimate in September. Labor force participation has still not risen as much as hoped, which may be contributing to challenges both with supply shocks (e.g. not enough truck drivers to deliver goods) and wage pressure.

AllianceBernstein provided an interesting interpretation of Wednesday’s events that gives some context for the Fed’s recent past and potential future. Eric Winograd argues that the Fed’s view of the Covid crisis has shifted over time, from its initial belief that it was mostly a demand shock, to a growing understanding that Covid’s later impact is largely as a supply shock. The Fed’s dual mandate is maximum employment and stable prices; given that current policy has yielded major unemployment progress along with a worrisome rise in inflation, the Fed would be expected to shift gears to address the latter.

The Fed is currently projecting 3 rate hikes for 2022, perhaps 1 rate increase more than many analysts expected—but even 3 rate increases next year would still leave rates at quite low levels historically. As for when interest rate increases begin, Winograd believes they will start once the Fed assesses the economy is at full employment, which he notes then begs the question: what is full employment? Winograd’s projection is that increased retirements and diminished retail employment would lead the Fed to conclude that the labor force participation rate may not reach pre- Covid levels, so that full employment, and consequent rate hikes, would arrive sooner rather than later, likely as soon as March. However, weak job reports, which show labor market loosening, or an unexpectedly high economic impact from the impending omicron wave, could cause the Fed to pause and reassess its interest rate policy.

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