Fed Speak, Beige Book, Underlying Inflation
In the category of “give credit where credit is due,” notice that Fed presidents are doing a better job of leading us to the next set of Fed rate projections than prior to the March Summary of Economic Projections. Heading into the March meeting, I complained that messaging from Fed presidents was too anchored on the December SEP which by March had become out of sync with both market pricing and economic reality. That dynamic has not been repeated as we approach the halfway point to the June SEP. Instead, even traditional Fed doves have rallied around the “get to neutral by the end of the year” story. For example, San Francisco Federal Reserve President Mary Daly, via the Wall Street Journal:
“I see an expeditious march to neutral by the end of the year as a prudent path,” with a rate that neither stimulates nor restrains the economy standing at around 2.5%, Ms. Daly said in a speech text. “We will continue to evaluate the data and the risks, but today I see little indication that the economy needs policy accommodation.”
Similarly, Chicago Federal Reserve President Charles Evans sees policy rates moving to the 2.25-2.5% range by the end of the year. Both forecasts compare to the seven 25bp rate hikes projected in the December SEP, meaning that Fed speakers are already telling us the June SEP will show the equivalent of at least nine, and likely ten, 25bp rate hikes for 2022. This is a welcome communications improvement on the prior December-March period.
Pushing rates to neutral by the end of the year requires a series of 50bp rate hikes, which we know begins at the upcoming May FOMC meeting. Speakers have positioned the Fed for 50bp rate hikes at the May and June meetings, and I believe the Fed will know at the June meeting if it plans to hike 50bp a third time in July as well. That sets the stage for the equivalent of ten 25bp rate hikes in the June dots, with the risk at that point that the Fed already believes it needs to get rates above current long-run neutral estimates by the end of the year, meaning a fourth and even fifth 50bp hike added to the series. That, however, is only speculation at this point. There will be a lot of data to process between now and then.
The Fed knows rates will need to move beyond current estimates of neutral, but doesn’t know or agree how far beyond. I suspect that the Fed is thinking the current rate projections are too low. The March SEP projected policy rates of 2.8% in 2023 and 2024 compared to a neutral rate of 2.4%. The problem with that outlook is that inflation will still be far too high at the end of this year. Back to Evans, via Bloomberg:
“Probably we are going beyond neutral,” Evans said Tuesday during a moderated discussion at an Economic Club of New York event.
“That’s my expectation, when I see that, taking out special factors, I’m still left with 3 to 3.5% inflation” by the end of 2022, he said. “That’s not what we want. If we’re at a 2.5% inflation rate, I think we have more things to ponder there.”
Note that Evans is looking through special factors, which would include falling used vehicle prices. This is important as falling used vehicle prices could give doves some leverage to slow the pace of rate hikes. If they can’t get Evans on board with that plan, it probably isn’t happening. As I have said in the past, keep your eye on measures of underlying inflation like supercore. That’s where I will be looking to assess the persistence of the inflationary shock filtering through the economy.
Still, even if the Fed is on the path toward well-above neutral rates, it doesn’t want us to price in too much just yet, hoping to guide rather than shock the economy into slower growth. Daly today:
If we slam the brakes on the economy by adjusting rates too quickly or too much, we risk forcing unnecessary adjustments by businesses and households, potentially tipping the economy into recession. If we ease on the brakes by methodically removing accommodation and regularly assessing how much more is needed, we have a good chance of transitioning smoothly and gliding the economy to its long-run sustainable path.
Daly also retains residual hope that the Fed can pause at neutral:
Once accommodation is removed, we need to evaluate the effects—observe how financial conditions adjust, how much inflation recedes, and what more remains to be done to ensure a sustained expansion.
I suspect by the time of the September (if not even the June) SEP, it will be clear that the Fed will need to raise more than modestly above its current estimate of long-run neutral rates, meaning that there will be little room for the kind of pause that Daly hopes for. This suggests that it will not be too long until the conversation shifts from pulling forward rate hikes to pushing up the projected terminal rate.
Separately, the latest Beige Book provides anecdotal confirmation of continuing elevated inflationary pressures. Overall activity is expanding at a moderate pace. Labor markets remain tight:
Employment increased at a moderate pace. Demand for workers continued to be strong across most Districts and industry sectors. But hiring was held back by the overall lack of available workers, though several Districts reported signs of modest improvement in worker availability. Many firms reported significant turnover as workers left for higher wages and more flexible job schedules. Persistent labor demand continued to fuel strong wage growth, particularly for footloose workers willing to change jobs. Firms reported that inflationary pressures were also contributing to higher wages, and that higher wages were doing little to alleviate widespread job vacancies. But some contacts reported early signs that the strong pace of wage growth had begun to slow.
And firms can push through higher prices onto customers and will continue to attempt to do so for the foreseeable future:
Inflationary pressures remained strong since the last report, with firms continuing to pass swiftly rising input costs through to customers. Contacts across Districts, particularly those in manufacturing, noted steep increases in raw materials, transportation, and labor costs. In multiple Districts, contacts reported spikes in prices for energy, metals, and agricultural commodities following the Russian invasion of Ukraine, and several noted that COVID-19 lockdowns in China had worsened supply chain disruptions. A few reports noted that input suppliers were making use of more flexible contract terms or only honoring price quotes for 24 hours. Strong demand generally allowed firms to pass through input cost increases to customers, for example, via fuel surcharges for freight and airline fares. However, contacts in a few Districts noted negative sales impacts from rising prices. Firms in most Districts expected inflationary pressures to continue over the coming months.
While there were some stories of easing wage inflation and demand destruction of inflation, these sound like more hope than reality at this point.
Finally, the New York Fed Liberty Street Blog presents research that points to a substantial increase in trend inflation:
In this post, we provide a model-based perspective on this narrative: large increases and decreases in monthly inflation during 2020 were largely the result of transitory shocks and outliers, with the trend component remaining relatively stable until early 2021, as common and sector-specific forces pulled in opposite directions. Sometime in the fall of 2021, the common persistent component came to dominate the evolution of the trend and today it stands as a significant driver of inflation. Sector-specific movements may have been relevant at the beginning of the pandemic but are currently playing a smaller role than common dynamics.
As I noted ahead of the release of the March FOMC meeting, staff research filtering its way up the food chain suggests that underlying inflation has already moved higher. That will only make the Fed more hawkish and increase the concern that it is not just a little behind the curve, it is a lot behind the curve.