US inflation hits new record, forcing the Fed to rethink its strategy

The thesis underpinning the US Federal Reserve Board’s monetary policy strategy is being severely challenged by the actual data. The facts are changing, so should the Fed change its mind?

Through this year, as inflation rates in the US pushed to levels not seen for 30 years, the Fed, led by chairman Jerome Powell, has insisted that the increase in prices was “transitory,” a function of the pandemic, and would subside as the economy normalised.

Even as inflation numbers remained at those three-decade highs, unemployment levels fell and the economy showed strong growth, the Fed maintained that broad thesis as it prepared for an orderly and cautious exit from its expansive response to the pandemic.

The high inflation rate may force Fed chair Jerome Powell to reconsider the US central bank’s next move.Credit:Bloomberg

The Fed is scheduled to begin “tapering” its $US120 billion-a-month ($164 billion-a-month) purchases of bonds and mortgage securities this month and end the program entirely by the middle of next year.

Powell has made it clear that the Fed won’t contemplate raising interest rates – the so-called “lift-off” – until it has ended the asset purchases. Minutes of recent Fed meetings show most board members don’t anticipate a rate increase until 2023.

But Wednesday’s inflation numbers may force the Fed to reconsider the pace at which its monetary policy evolves.

The US inflation rate for October came in well above market expectations at 0.9 per cent, or 6.2 per cent on a year-on-year basis – the highest rate since mid-1982 and an acceleration from September’s 5.4 per cent.
Core inflation (excluding fuel and food) rose 0.6 per cent in the month and 4.6 per cent year-on-year, the largest rise since 1990.

Disconcertingly for the Fed, where the surge in inflation earlier this year was concentrated in the sectors most affected by the pandemic and then the re-opening of the economy, the base of price growth now seems to be broadening. Rising inflation is becoming baked in as the accelerating increases in prices for goods and services are being passed on and are also being reflected in wages rising at rates not seen since the early 1980s.

The disruptions to supply chains that are a key driver of the burst of inflation show no signs of being resolved. Neither do energy costs, which have roughly doubled over the past year to the $US80-plus a barrel of oil levels last seen, briefly, in 2018.

The dilemma for the Fed is the knowledge that the supply chain bottlenecks should eventually be cleared. There is also the prospect that OPEC (and/or US shale producers) might increase oil production sufficiently to produce a more even balance of supply and demand in energy markets.

The acceleration in inflation will inevitably force the Fed to at least consider whether it will need to speed up its exit from quantitative easing and/or bring forward the first rate rise.

The risk is that if the central bank waits too long for those things to happen, it might lose control of inflation and self-fuelling inflationary expectations.

It’s not surprising that financial markets have taken matters into their own hands.

The five-year “break-even rate” — the difference between the yields on inflation-protected bonds and conventional Treasuries with the same duration, which reflects market expectations of future inflation – widened 14 basis points to a record 3.13 per cent.

The yield on two-year notes jumped 9 basis points to 0.52 per cent as the US yield curve flattened in expectation that the Fed will be forced to move ahead of its schedule and truncate the post-pandemic rebound in economic growth in the process.

‘Taper tantrums’

The acceleration in inflation will inevitably force the Fed to at least consider whether it will need to speed up its exit from quantitative easing and/or bring forward the first rate rise in this cycle to next year.

The October inflation numbers shocked the bond market but only rattled equity markets, with the S&P 500 falling only 0.82 per cent. The more rate-sensitive Nasdaq market, laden with high price-earnings ratio technology stocks, fell 1.66 per cent.

But should the Fed’s hand be forced, the likelihood is that there’d be “taper tantrums” — more substantial sell-offs — in both bond and equity markets. The more entrenched the higher inflation levels become, and the longer the Fed waits to respond, the more violent the markets’ responses might be.

The Fed’s decision-making is complicated by US President Joe Biden’s ambitious agenda.

Having just gained Congressional approval for his $US1.2 trillion infrastructure spending package, the White House is now trying to negotiate the even more difficult route to approval for its proposed $US1.75 trillion of social and climate-related spending.

Powell’s predicament

If that approval can be gained – and the divisions even within Biden’s own party make that problematical – the US would be pouring fiscal fuel onto the already flaring inflation rate.

Powell’s predicament is also complicated by the fact that his position at the Fed is up for grabs, with his term scheduled to end in February. Biden interviewed both Powell and another highly-regarded Fed board member, Lael Brainard, at the White House last week.

If Powell isn’t granted a second term as chair, Brainard, favoured by the progressive elements among the Democrats – and the markets — was seen as the obvious and uncontroversial choice.

She is, however, also seen as even more “dovish” and more unlikely to accelerate the taper or support an early rate rise than Powell and is therefore perhaps not the ideal candidate to deal with a sustained burst of inflation.

The outbreak of inflation at levels not seen for decades isn’t, of course, confined to the US.

Data also released on Wednesday showed that factory-gate inflation in China hit 13.5 per cent last month – its highest level since 1995 – as the supply chain issues, the country’s energy crisis and soaring commodity prices (which have since peaked) raised fears of stagflation, or high levels of inflation and low economic growth.

Similar pressures from the supply chain disruption and higher energy and food prices are affecting central and eastern Europe and much of Asia and, to a less dramatic extent, Australia.

There is some irony in the markets’ and central bankers’ fears of an inflationary spiral.

Before the pandemic, their biggest concern was the absence of inflation in the post-financial crisis era, with a lot of research, analysis and head-scratching by central bankers and economists looking into its absence and into ways to spark price growth.

It now seems you can have too much of a good thing. The new conundrum is how to manage inflation down without destroying the post-pandemic rebound in economic growth in the process.

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