A spectre stalks the land – inflation. Prices are rising at an annual rate of about 7 percent, the fastest in four decades. The Fed’s preferred measure clocks in at 5.8 percent in December, also the fastest since 1982. Recently reappointed Federal Reserve Board chairman Jay Powell, the adjective “transient” deleted from his vocabulary, unembarrassed at being mugged by reality and forced into a policy U-turn, now describes inflation as “slightly worse” than last month, and “elevated.”
Price increases have brought tears to the eyes of grown truckers as they watch dials spin on gas pumps, more than offset the wage increases workers have garnered, and forced shoppers to seek cheaper alternatives to their usual brands, which alternatives are decreasingly if at all available as producers concentrate on the more expensive products in their portfolios. Ford, for example, has stopped taking orders for its low-priced ($20,000) pick-up trucks, concentrating on pricier models that average between $35,000 and $70,000, and many consumers are switching to cheaper store brands of pasta, bacon, frozen fruits and other items. Investors, at last recognizing a long-foreseeable move by the Fed to take away the proverbial punch bowl, have taken share prices on a roller-coaster ride that has ended with the S&P 500 closing down 7.6 percent from its January 3rd record high, but still more than 19 percent above where it closed last year which, as we say in New York, “ain’t chopped liver”.
The Fed plan to rein in inflation has three steps.
· First, it will “taper” the rate at which it purchases treasury bonds and mortgage securities.
· Second, when those purchases end in March, it will begin raising interest rates, perhaps five (JPMorgan) or seven (BofA) times, perhaps by one-quarter of a percentage point each time. But possibly by more: Powell studiedly refuses to use the word “gradual”, prompting such as David Kelly, chief global strategist at J.P. Morgan Asset Management, who grumbles that the Fed is 40 years too late, but nevertheless fears the consequences if the Fed “slams on the brakes”. “Humble and nimble” are the chairman’s words du jour.
· Third, the Fed will begin a process of “significantly reducing” its bloated $9 trillion balance sheet – double its pre-Covid level – by adjusting how much it reinvests as its assets expire. If confirmed, some of Biden’s new nominees will be concerned about just which assets are allowed to disappear from the balance sheet and which must be renewed, perhaps for reasons unrelated to the Fed’s mandate as traditionally defined.
Meanwhile, Powell concedes that employers’ difficulties in filling job openings will continue to drive up wages and that supply bottlenecks “will persist well into next year”. He knows that food processors, transportation companies and others again raised prices earlier this month. McDonald’s is estimating that its costs will rise twice as fast this year as they did last, when it raised prices about 6 percent. Nevertheless, Powell continues to “expect inflation to decline over the course of the year.”
He is counting on several developments to help the Fed realize that expectation. Fiscal policy will tighten and “will provide less of an impulse to growth … in fact, negative this year.” It is not that the President has suddenly become parsimonious. Rather, Republicans won’t go along with extension of $300 monthly per-child payments, and dissidents within his own party won’t agree to Build Back Better as it is now drawn.
Also, some of the workers who have dropped out of the labor force since the pandemic began – Powell puts the number at 5 million – will re-enter, as benefits expire and excess savings are consumed. An anticipated sharp drop in the infection rate of the Omicron variant would permit an estimated 8.7 million workers pinned down at home because of Covid or the need to care for someone who had the virus to return to the work force. Pressure on wages will subside.
Perhaps. But Inflationary expectations by workers with some bargaining power have led to the introduction of Cost of Living Adjustment clauses in new wage contracts. Those workers, still a minority, will have their pay increased to keep pace with rising prices. Employment costs – wages and benefits – are rising at the fastest rate in the two decades in which records have been kept.
Material and labor shortages have forced up construction costs, demand is robust, and “elevated” home prices and rents are unlikely to fall absent a major recession. Auto makers, feasting on profit margins created by their emphasis on the most expensive models, are not likely to create a supply glut to bring back bargain prices until chips become more available, and with chip inventories down to five days’ supply from 40 days in 2019, that day is far off.
Fortunately, the economy is strong, the havoc recently wreaked by Omicron unlikely to prove permanent. It grew at a 6.9 percent annual rate in the final quarter of last year. Most reductions in growth forecasts still foresee an economy growing faster than its 2-2.5 percent trend rate of growth. Goldman Sachs has cut its 2022 forecast from 4.2 percent to 3.8 percent. The International Monetary Fund projects 4 percent growth, down from its October forecast of 5.2 percent.
So, too, is the labor market. The unemployment rate is a low 3.9 percent, giving the Fed what Powell calls “quite a bit of room to raise interest rates without threatening the labor market”. The stock market, of course is more easily threatened now that “the party’s over, it’s time to call it a day, they’ve burst your pretty balloon”, to borrow from Betty Comden and Adolph Green.
All will depend on the Fed’s ability to calibrate its response to incoming data to avoid both too much too soon and a continuation of too little too late, all pain and no gain. The c