Fed Pivots to Price Stability Mandate for 2022

We mentioned, not long ago, that once inflation had jumped from a business section story to the front pages the Fed would have to be seen as doing something, and Wednesday’s FOMC meeting fulfilled that demand. While Fed Chair Powell’s congressional testimony two weeks ago signaled the coming pivot to combat inflation, the Wednesday meeting made good on that signal in spades.

First and foremost, there is the refreshed dot plots of expected fed fund rates. In September, the Fed was split 50/50 on whether they would manage one rate hike in 2022. Just three months later, nine of seventeen participants saw three rate hikes in 2022, with another two expecting four hikes. That gives you a clear sign how quick and pervasive was the pivot to inflation-fighting at the Fed.

Returning to the labor market mandate, Powell said that if inflation expectations become unmoored, reaching maximum employment would be impossible. In that one statement, he not only tied beating back inflation as key to the price stability mandate but also to the full employment mandate. The accelerated tapering schedule (now due to finish in March) became an afterthought. For the first time in a generation, the Fed will be firmly fixated on inflation risk and the full employment mandate will just have to deal with it.

Rate Hikes in Store for 2022, but How Soon and How Many?

As mentioned above, the pivot from jobs to inflation-fighting between the September and December FOMC meetings was stark. As shown in the latest dot plot fully nine participants expected to hike rates three times next year. In September, the committee was evenly split between no hike and one hike. The string of hotter-than-expected inflation readings from almost every source: CPI, PPI, PCE, all signaled much higher and longer-lasting inflation than was thought would be the case just a couple months earlier.

Source: Bloomberg

It’s interesting to note that despite the current bout of inflation, while the highest in decades, it is not enough to sway the committee to considering a lift to the longer term rate of 2.50%. That signals that the Fed still believes most of the price increases will turn out to be somewhat transitory, although that word has now been stricken from the Fed dictionary.

With the accelerated tapering schedule almost an afterthought, in the wake of these rate-hiking projections, it’s now expected to be wrapped up by March. Would that lead to the first rate hike at the March 16 meeting? It’s possible. If inflation readings continue to remain at recent levels the Fed may feel compelled to get on with rate hikes.

Also, with the Omicron variant likely to hamstring supply chains anew, those supply-driven price increases are not likely to recede anytime soon. If this pivot to fighting inflation has taught us anything it is that the data will guide the Fed’s policies. They most certainly are not wedded to a pre-set course. By late February, or early March, it should be pretty clear when the rate-hiking will begin.

Fed Not Willing To Let Inflation Expectations Become Unmoored

One of the key points in the Fed’s pivot to full-on inflation fighting is the concept of inflation expectations. That is, what does a consumer, or business owner, expect in regards to future inflation. If they expect higher levels, or increasingly higher levels, they will react accordingly. The consumer will tend to buy now versus waiting for later, creating a demand-pull effect on prices. The business owner is likely to raise prices preemptively so as to stay ahead of the expected inflationary forces. That action too creates a spiraling of ever higher prices.

Source: Bloomberg

The graph above shows a long-run view of inflation, in this case core CPI, and the effective fed funds rate. The spike in both in the late 70s and early 80s is a result of then Fed Chair Paul Volker’s attempt to wring inflation, and inflation expectations, from the economy. As inflation gathered steam in the late 70s, consumers, and business owners, expected ever-increasing rates of inflation, which led to a self-fulfilling prophecy of higher prices.

Those higher fed funds rates contributed to a couple recessions during that time, as shown by the red bands. That was a painful period for all who lived through it, and something the Fed does not want to repeat. Over the intervening decades you can see the general decline in inflation. That led to an anchoring of inflation expectations at low levels which the Fed does not want to lose; thus, the hard pivot that we saw in the December FOMC meeting.  Those hard-won gains of the 80s in anchoring inflation expectations still guide much of today’s Fed policy, and probably for good reason.

Agency Indications — FNMA / FHLMC Callable Rates

Maturity (yrs) 2 Year 3 Year 4 Year 5 Year 10 Year 15 Year
0.25 0.63 0.97 1.18 1.45 1.93 2.40
0.50 0.62 0.94 1.12 1.34 1.79 2.28
1.00 0.61 0.91 1.09 1.29 1.70 2.16
2.00 0.90 1.03 1.21 1.58 NA
3.00 1.17 1.52 NA
4.00 1.47 NA
5.00 1.44 NA
10.00 NA

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Published: 12/16/21 Author: Thomas R. Fitzgerald