Tim Duy’s Fed Watch, 9/28/21

Published on September 28, 2021
SGH Insight
Regarding inflation, Brainard expects this year’s surge to be transitory, placing particular attention on used-car prices:

Next let's consider price stability. Inflation is currently elevated. This is creating challenges for consumers and businesses alike. But the high inflation readings from the spring and early summer were disproportionately driven by a few sectors experiencing specific supply bottlenecks. In May and June, new and used vehicle prices accounted for half of the outsized monthly increases in core consumer price index (CPI) inflation. These categories were lesser contributors in July, and in the August CPI their joint contribution declined to essentially zero, as prices finally began to retreat for used cars, offsetting increases in new car prices.

With that in mind, note this from Black Book:

Traditionally, as we move past Labor Day, values begin to decline, with the largest portion of the yearly depreciation typically occurring in the fourth quarter. However, that is not the case this year, we’ve now had four consecutive weeks of overall market increases in wholesale values. With new inventory not expected to improve until later into 2022, wholesale prices are anticipated to remain at elevated levels for the foreseeable future.

The seasonal factors will magnify used car price growth if they are again rising when seasonally they should be falling. Brainard recognizes such a possibility:

So, I expect inflation to decelerate, and pre-COVID inflation dynamics to return when COVID disruptions dissipate. But with Delta disrupting the rotation from goods to services and prolonging supply bottlenecks, it is uncertain just how fast and how much inflation will decelerate over the remainder of the year and into next year.

Market Validation
Bloomberg 10/7/21

Used-car prices, one of the biggest factors in U.S. inflation this year, rose to an all-time high in September as pandemic-driven supply-chain disruptions continued.
The Manheim U.S. Used Vehicle Value Index, a measure of pricing trends at wholesale auctions, increased 5.3% in September from a month earlier, the biggest monthly gain since April. The index is now up 27.1% from a year earlier.
Global supply-chain snags have hit new-vehicle production schedules, pushing some consumers into the used-car market and leading dealers to step up their buying efforts, according to the Manheim report, released Thursday. Retail used-car prices will likely remain elevated in the months ahead, it said.
Used-car prices have been a major contributor to U.S. inflation this year, responsible for about 2% of overall consumer prices. The August consumer price index report showed a decline in used-car and truck prices, but that was a temporary pause rather than a peak.


Fed Presidents Resign, Brainard Speech, Energy Prices

Federal Reserve Presidents Eric Rosengren and Robert Kaplan resigned Monday in the wake of an ethics controversy regarding their trading activity during the pandemic. It wasn’t a good look for the Fed, and when the issue was raised at last week’s press conference Federal Reserve Chair Jerome Powell appeared visibility upset by the entire episode. With the resignations of Rosengren and Kaplan, the Fed may have helped diffuse the issue ahead of upcoming confirmation meetings.

Both Rosengren and Kaplan forecast a rate hike in 2022 and without those two dots, the median FOMC participant would delay lift off until 2023. While this raises the prospect that those dots will change in the December SEP, I think it’s most likely that the interim presidents, Dallas First Vice President Meredith Black and Boston First Vice President Kenneth C. Montgomery, will maintain the status quo until the banks secure replacements for the top spots. In addition, both will have the same staff feeding the forecasts. It is quite rare for a district to completely switch stripes.

Looking further ahead, I think it is reasonable to expect the eventual replacements will not be more hawkish than Rosengren and Kaplan and instead more likely that at least one of the two will be more dovish, perhaps Boston. Also, the trend across the Fed has been to push for a more diverse and equity-oriented candidate pool, which could imply a greater focus on the employment side of the Fed’s mandate. Having said that, the rotation of FOMC voting Presidents next year will switch that group into clearly more hawkish hands.

Separately, this is a busy week for Fed speak and too much for any one note. One highlight from today was a meaty speech by Federal Reserve Governor Lael Brainard. She identified the economic impacts of the Delta virus as coming from both the demand side, largely weaker spending in leisure and hospitality, and the supply side, supply chain constraints and a slower rebound of labor supply. Regarding labor supply, Brainard acknowledges the high level of job openings relative to the number of unemployed but notes:

Some cite this ratio of job openings to job seekers as indicating we are close to full employment. But virus conditions may be driving an important wedge between labor supply in the near term relative to the medium term.

She adds:

The assertion that labor force participation has moved permanently lower as a result of a downturn is not new. Indeed, it has been a regular feature of the early stages of recent recoveries. Research demonstrates that the labor force participation rate cycle lags that of the unemployment rate by years. So, it is important to consider indicators beyond the headline unemployment rate when assessing progress toward maximum employment, as participation gains might come late in the recovery for some groups.  For these reasons, I see no reason employment should not reach levels as strong or stronger than before the pandemic.

The initial rapid partial rebound in labor force participation last year may have pushed us to be overconfident in the ability of labor supply to rebound. Brainard helpfully reminds us that labor force participation is often a lagging indicator. As the adage goes, time heals all wounds eventually.

That said, typically periods of weak labor demand follow recessions, and we might expect in such a period labor force participation would also be weak to respond. The current cycle is characterized by strong labor demand which in theory should have encouraged transitions into the labor force, especially given the upward pressure on wages. Also, Brainard’s “wedge” in the labor supply over the near term lends itself to the proposition that the short-term natural rate of unemployment has risen. Even if, as Brainard reasonably expects, this is not a permanent situation, it offers up the tantalizing possibility of near-term overheating of the labor market. Time heals all wounds, but they can fester before they heal.

Regarding inflation, Brainard expects this year’s surge to be transitory, placing particular attention on used-car prices:

Next let’s consider price stability. Inflation is currently elevated. This is creating challenges for consumers and businesses alike. But the high inflation readings from the spring and early summer were disproportionately driven by a few sectors experiencing specific supply bottlenecks. In May and June, new and used vehicle prices accounted for half of the outsized monthly increases in core consumer price index (CPI) inflation. These categories were lesser contributors in July, and in the August CPI their joint contribution declined to essentially zero, as prices finally began to retreat for used cars, offsetting increases in new car prices.

With that in mind, note this from Black Book:

Traditionally, as we move past Labor Day, values begin to decline, with the largest portion of the yearly depreciation typically occurring in the fourth quarter. However, that is not the case this year, we’ve now had four consecutive weeks of overall market increases in wholesale values. With new inventory not expected to improve until later into 2022, wholesale prices are anticipated to remain at elevated levels for the foreseeable future.

The seasonal factors will magnify used car price growth if they are again rising when seasonally they should be falling. Brainard recognizes such a possibility:

So, I expect inflation to decelerate, and pre-COVID inflation dynamics to return when COVID disruptions dissipate. But with Delta disrupting the rotation from goods to services and prolonging supply bottlenecks, it is uncertain just how fast and how much inflation will decelerate over the remainder of the year and into next year. 

Brainard helpfully tells us what she is looking for as signals that her inflation forecast is too optimistic:

First, while rent and owners’ equivalent rent both rose a moderate 0.3 percent in the August CPI data, if housing services inflation moved up substantially more than expected, it could provide durable upward pressure on inflation. Second, there is a risk that goods prices may not decelerate and return to pre-COVID trends as is widely expected, for instance, if excess savings or disruptions to services result in persistently elevated goods demand. Third, I will be watching for any signs that wage gains are feeding into higher inflation more broadly, but the evidence so far suggests that wage gains are broadly in line with productivity growth, and the labor share of income remains low relative to historical levels. To date, high markups and non-wage input costs appear to be more notable contributors to inflation than wage pressures.

She leans into the inflation expectations story:

Finally, I am vigilant for any signs that the current high level of inflation might push longer-term inflation expectations above levels consistent with our 2 percent inflation objective. 

I covered the criticism of that story heavily in yesterday’s note. Regardless of the theoretical or empirical validity of the use of inflation expectations, Fed officials use the stability of those expectations as a basis for their conviction that inflation will return to target. As I expected, Brainard found comfort in the New York Fed’s effort to diminish its own finding of rising medium-term expectations:

Survey-based measures also suggest longer-run expectations remain well anchored. Recent analysis of the Survey of Consumer Expectations (SCE) concludes that “in August 2021 consumers’ five-year ahead inflation expectations were as well anchored as they were two years ago, before the start of the pandemic.”

New York Federal Reserve President John Williams also appealed to the same results in a speech yesterday. I don’t think the appeal to inflation expectation is disingenuous. Policymakers are looking for guidance to manage a more challenging environment, one of repeated supply shocks rather than the typical demand shocks. They are reaching for tools that have served them well in past, particularly the belief that stable inflation expectations allow policy to be less attentive to supply shock-driven inflation. That said, I am concerned that the measurement of inflation expectations is squishy enough to give you whatever answer you want once you start slicing and dicing the data. Don’t like three years, how about five years, or ten? What’s the distribution of the respondent’s forecast? Are the results driven by the tail? You get the idea.

Brainard concludes that the future will be like the past:

While inflation has been well above target for the past six months, affecting consumers and businesses alike, it previously spent roughly a quarter century below 2 percent. There are good reasons to expect a return to pre-COVID inflation dynamics due to the underlying structural features of a relatively flat Phillips curve, low equilibrium interest rates, and low underlying trend inflation. While the playbook for guiding inflation back down to target following a moderate overshoot is well tested and effective, experience suggests it is difficult to guide inflation up to target from below.

My questions of inflation expectations aside, I agree that the long period of low underlying inflation is something that should not be ignored; it’s the base case because any other case assumes a change in the underlying inflation dynamic that has yet to become visible. I suppose I have a certain affinity for the argument that “the trend is your friend.” That said, I also see all the pieces that put together could trigger such a change and am wary of too easily dismissing that outcome.

Brainard explains the implication of her analysis:

So what do these developments imply for the path ahead? One clear lesson is that we need to be humble about our ability to correctly anticipate future economic conditions given the unpredictability of the virus. We had expected a smooth rotation from goods spending to services spending during a complete reopening this fall, but Delta has slowed this process. Partly as a result, employment gains flatlined in August in the leisure and hospitality sector, where many of the job losses have occurred. As a result of Delta, the September labor report may be weaker and less informative of underlying economic momentum than I had hoped.

That last line creates the flexibility to ignore a weak September employment report and move forward with plans to announce tapering at the November meeting. Also note the attention to just the September report; if Brainard expected or wanted to make the case for a delay, she could talk about multiple reports. I read this as another signal of the consensus that November is a done deal barring a dramatic change in economic or financial conditions (think debt ceiling crisis). Brainard adds what has become a standard disclaimer:

 I would emphasize that no signal about the timing of liftoff should be taken from any decision to announce a slowing of asset purchases. We have learned this summer that it is important to remain highly attentive to the data and to avoid placing too much weight on an outlook that remains highly uncertain.

The dots in the SEP are just forecasts, not promises. And while tapering clears the way for rate hikes, conditions might change such that rate hikes are pushed further out into the future. That said, the opposite might happen as well.

On a final note, watch energy prices. Via MarketWatch:

Prices for U.S. and global benchmark crude oil settled Monday at the highest in almost three years, and natural-gas futures rallied back to levels not seen since February 2014, buoyed by tight U.S. supplies and strengthening demand.

Rising energy prices in an environment of elevated inflation will keep the public increasingly focused on inflation. This would be another in what is becoming a long series of unfortunate supply shocks; such repeated shocks raise the risk of supporting a shift in the underlying inflation trend. Something to keep an eye on.

Bottom Line: In Brainard’s speech, you can see the next narrative forming. Hawkish on taper, it’s essentially a foregone conclusion. At the same time, dovish on rates by using the combination of suboptimal labor market and entrenched inflation expectations to argue for patience on rate hikes and detach the rate lift off from tapering. Still, note an increasingly wary eye on the rolling supply shocks.

 

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