Is the inflation outlook as benign as the Fed said?
The Jackson Hole symposium is supposed to be a largely academic affair, but this year Federal Reserve (Fed) chair Jay Powell had an opportunity to steer markets around the likely timing of tapering.
In the event, Powell chose to repeat the line contained in the previous Federal Open Market Committee (FOMC) minutes – that it could be appropriate to start reducing the pace of asset purchases this year.
More interesting for us, then, was Powell doubling down on the view that inflation is likely to prove transitory. This comes at a time when inflation has continued to surprise positively and, by Powell’s own admission, businesses and consumers widely report upward pressure on prices and wages.
Powell nevertheless gave five reasons to believe these elevated readings are likely to be temporary:
1) The lack of breadth behind the inflation spike. We largely agree with this assessment. Measures such as the median CPI have been relatively well behaved. However, we will be watching carefully should we see signs of broadening, especially in traditionally more sticky services.
2) Moderating inflation in pandemic-sensitive components. No dispute from us here. Used-car prices appear to have flattened off and indeed we expect them to become a large drag on inflation in 2022 as prices fall back to more normal levels.
3) Wages that remain consistent with inflation goals. While true, it is surprising that wages have not been weaker given the rise in unemployment. With demand expected to continue growing well above trend, if labour-force participation fails to fully recover the danger is that wage pressures intensify next year.
4) Stable long-term inflation expectations. Again true, but our research finds that the formation of inflation expectations is largely adaptive, so the risk is that the longer actual inflation remains elevated the more it might begin to place upward pressure on inflation expectations.
5) Global disinflationary pressure. Powell believes there is little reason to think this has suddenly reversed or abated. We nevertheless find evidence that some of the factors could be moderating, as globalisation seems less intense with countries increasingly looking inward and becoming more protectionist. Fiscal policy, while not yet fully embracing modern monetary theory, appears far less disciplined. Finally, and perhaps most important, is the shifting behaviour of central banks, led by the Fed. Its new framework is a commitment to run the economy hot, partly because it believes continued global disinflationary pressure and well anchored inflation expectations will ensure any inflation increase is so gradual it will have time to adjust policy smoothly.
All in all, Powell could well be proved correct. We also expect inflation to fall back to target for a while next year, but risks to this sanguine inflation outlook appear to the upside.