US monetary policy: The risks are two-tailed

Summary

The COVID recession was relatively short, but the knock-on effects of the pandemic and the fiscal policy response look set to linger well into next year. Inflation has soared to an a30-year high, and the FOMC has come around to the view that heightened inflation is likely to persist longer than initially thought. Expectations for raising the fed funds rate have been pulled forward as a result. Markets are pricing in the fed funds rate liftoff by September of next year compared to the Fed's most recent projections pointing to 2023. Is the accelerated timeline warranted with the inflation we see today?

Whether earlier Fed tightening will avoid a policy mistake or lead to one depends on the drivers of inflation. "Supply" has taken much of the blame for the run-up in inflation over the past six months or so, but in our view, much of the discussion oversupply constraints conflates the underlying drivers. For monetary policymakers, there is a difference between shortages due to production and transportation disruptions and shortages due to excessive demand. While both of these forces are at work in the current environment, we believe the latter is the bigger driver of elevated inflation right now. The level of aggregate demand looks relatively healthy, but the mix of demand remains significantly out-of-balance. Specifically, goods consumption remains elevated compared to its pre-COVID trend, and surging goods prices have pushed inflation to the highest pace in decades. In addition, supply has not recovered across the entire economy, most predominately when it comes to labor.

This puts the Fed between a rock and a hard place. It could wait to tighten policy until it is clear that inflation pressures are more entrenched and broad-based, but falling" behind the curve" risks an ultimately stricter policy stance that could induce a recession. Alternatively, the Fed could tighten policy earlier to tamp down demand in certain interest-rate-sensitive categories such as durable goods and housing, as well as keep inflation expectations from becoming unmoored. But would this latter approach prove effective at returning inflation to the Fed's target without derailing the recovery?

In our view, the unique drivers of the current inflation environment likely make inflation less sensitive to rate hikes than is normally the case. For example, tighter monetary policy can not contain COVID, pull workers back into the labor force nor resolve short-term production outages. Tightening aggressively when the economy is still transitioning to its post-pandemic state risks a hard landing, and the lagged effect of monetary policy risks slowing the recovery at a time when buying patterns and spending growth are already normalizing. It also risks choking off the labor demand that is likely to be the best bet for eventually drawing more workers back into the workforce, resolving labor supply woes, and achieving maximum employment.

For now, we think the FOMC will be content to let the tapering of its asset purchases continue over the next few months while offering little firm forward guidance one way or the other on future rate hikes. If this seems a bit odd, bear in mind that the FOMC may be concerned about a policy mistake in both directions.

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