Tim Duy’s Fed Watch, 11/29/21 (2)

Published on November 29, 2021
SGH Insight
He is clearly saying Omicron will present another supply side shock. It will be slowing progress in the labor market by holding back supply when wage inflation is already “brisk.” It will be adding to inflationary pressures via supply chain disruptions. In short, it’s driving a bigger wedge between the Fed’s employment and inflation mandates. That wedge is already driving the Fed to pivot away from the employment mandate (although I think it can declare full employment whenever it wants) and toward the inflation mandate. Omicron, if realized as another Delta-type wave, would increase, not decrease, the need to pivot toward inflation. The Fed can’t keep easing into supply shocks and FOMC participants know it. Recall also that the Fed sent strong tapering signals during the Delta wave and ultimately pulled forward the taper despite Delta.
Bottom Line: It could be that Powell comes off dovish under questioning, but this testimony is clearly hawkish relative to the September version. I think the short story is that even if inflation is still expected to be transitory, it is now too persistently high to be ignored and Omicron would only make inflation worse. The public doesn’t like inflation, the politics are turning hard against the Fed and the administration, and the quite frankly inflation is comically above the Fed’s mandate, or as Powell says, “overall inflation is running well above our 2 percent longer-run goal.” I don’t think the Fed changes course unless Omicron reveals itself to be something different than Delta. That means assuming the jobs and inflation numbers come is as expected, I expect the Fed will accelerate the taper at the next meeting. Powell though could pull another move like in September and all but promise a faster tapering in January instead. Of course, I am watching for signs that won’t happen, but I don’t see those signs in this testimony.
Market Validation
Bloomberg 11/30/21

Treasuries Pare Gains After Powell Cites Higher Inflation Risks

Treasury futures knocked from highs of the day on high volumes after Fed Chair Powell says the risk of higher inflation has increased.
U.S. 10-year note futures drop around 16 ticks from highs of the day with around 40k Mar22 contracts trading over 3-minute period
U.S. 10-year yields remain richer by ~5bp on the day after climbing around 4bp from near session low after Powell’s comment; 2-year yields flip to 1bp cheaper on the day at around 0.495%
*POWELL: TIME TO RETIRE THE WORD TRANSITORY REGARDING INFLATION
*POWELL: THREAT OF PERSISTENTLY HIGHER INFLATION HAS GROWN

Quick Note on Powell

After the market close today the Fed released Chair Jerome Powell’s written testimony for his Tuesday trip to Capitol Hill. I think it leans hawkish. First, on the labor market, Powell says:

As with overall economic activity, conditions in the labor market have continued to improve. The Delta variant contributed to slower job growth this summer, as factors related to the pandemic, such as caregiving needs and fears of the virus, kept some people out of the labor force despite strong demand for workers. Nonetheless, October saw job growth of 531,000, and the unemployment rate fell to 4.6 percent, indicating a rebound in the pace of labor market improvement. There is still ground to cover to reach maximum employment for both employment and labor force participation, and we expect progress to continue.

Look how Powell frames the job slowdown this summer related to the Delta surge. He does not describe it as the result of slowing demand. Instead, he very clearly says labor demand is strong and attributes slow job growth to the negative impact of Delta on labor supply. That’s the story of Covid waves as a series of supply side shocks. Note also how he describes the employment goals as “ground to cover.” He could have said “much ground to cover” but instead chose language that suggests the Fed is closer than farther from meeting its employment mandate.

On inflation, Powell says:

Pandemic-related supply and demand imbalances have contributed to notable price increases in some areas. Supply chain problems have made it difficult for producers to meet strong demand, particularly for goods. Increases in energy prices and rents are also pushing inflation upward. As a result, overall inflation is running well above our 2 percent longer-run goal, with the price index for personal consumption expenditures up 5 percent over the 12 months ending in October.

It’s not supply chain problems alone that are causing inflation, it’s also “strong demand.” Demand management is the Fed’s job, and if strong demand is playing a role in driving inflation, even if not the primary role, the Fed still can weigh against inflation with tighter policy. In other words, once the Fed admits demand factors are at play in the inflation numbers, the Fed admits it can do something about inflation. Also note that inflation isn’t just about a few items anymore; his concerns have broadened out to energy and rent. Energy might get some relief here with the oil price decline, but rents are still going up.

On the outlook, Powell says:

Most forecasters, including at the Fed, continue to expect that inflation will move down significantly over the next year as supply and demand imbalances abate. It is difficult to predict the persistence and effects of supply constraints, but it now appears that factors pushing inflation upward will linger well into next year. In addition, with the rapid improvement in the labor market, slack is diminishing, and wages are rising at a brisk pace.

Powell is saying upward pressure on inflation will continue in the context of an economy rapidly approaching full employment (“diminishing” slack, wage inflation at a “brisk” pace). If the economy is rapidly approaching full employment while facing persistent inflationary pressures, the Fed is going to want to start backing off accommodative policy more quickly because it expects to hit the condition for a rate hike sooner (“rapid” improvement). A natural extension would be that the Fed needs to conclude asset purchases more quickly. Powell is not going to say that during testimony, of course. That would be front running the FOMC decision.

We understand that high inflation imposes significant burdens, especially on those less able to meet the higher costs of essentials like food, housing, and transportation. We are committed to our price-stability goal. We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched. 

The Fed can’t ignore inflation as a temporary inconvenience anymore and the Fed views inflation as an equity issue. It’s a “significant burden” to those “less able to meet” higher prices. This gives justification to lean against inflation as part of the battle against inequality just like maximum employment was framed as a broad and inclusive goal. Critically, Powell says the Fed “will use our tools.” In his September testimony on that CARES Act, Powell said:

If sustained higher inflation were to become a serious concern, we would certainly respond and use our tools to ensure that inflation runs at levels that are consistent with our goal.

In September, Powell said if inflation were to become a concern, the Fed “would” respond. That’s a conditional statement. The condition for using tools, a serious concern about inflation, has been met and now the Fed “will” use its tools to prevent higher inflation from becoming entrenched. If the Fed wants to do that, it probably doesn’t want the economy hitting full employment at full speed with brisk wage growth when inflation is still elevated, and rates are still at zero. They need to be prepared to raise rates.

On Omicron, Powell says:

The recent rise in COVID-19 cases and the emergence of the Omicron variant pose downside risks to employment and economic activity and increased uncertainty for inflation. Greater concerns about the virus could reduce people’s willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions.

He is clearly saying Omicron will present another supply side shock. It will be slowing progress in the labor market by holding back supply when wage inflation is already “brisk.” It will be adding to inflationary pressures via supply chain disruptions. In short, it’s driving a bigger wedge between the Fed’s employment and inflation mandates. That wedge is already driving the Fed to pivot away from the employment mandate (although I think it can declare full employment whenever it wants) and toward the inflation mandate. Omicron, if realized as another Delta-type wave, would increase, not decrease, the need to pivot toward inflation. The Fed can’t keep easing into supply shocks and FOMC participants know it. Recall also that the Fed sent strong tapering signals during the Delta wave and ultimately pulled forward the taper despite Delta.

Bottom Line: It could be that Powell comes off dovish under questioning, but this testimony is clearly hawkish relative to the September version. I think the short story is that even if inflation is still expected to be transitory, it is now too persistently high to be ignored and Omicron would only make inflation worse. The public doesn’t like inflation, the politics are turning hard against the Fed and the administration, and the quite frankly inflation is comically above the Fed’s mandate, or as Powell says, “overall inflation is running well above our 2 percent longer-run goal.” I don’t think the Fed changes course unless Omicron reveals itself to be something different than Delta. That means assuming the jobs and inflation numbers come is as expected, I expect the Fed will accelerate the taper at the next meeting. Powell though could pull another move like in September and all but promise a faster tapering in January instead. Of course, I am watching for signs that won’t happen, but I don’t see those signs in this testimony.

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