Sources: MacKay Shields, Bureau of Labor Statistics, 12/10/21. Core consumer price inflation is overall consumer price inflation, less food and energy. The Cleveland Fed trimmed-mean consumer price index attempts to measure underlying inflation trends by removing volatile items. *Select goods prices include new, used, and rental vehicles, recreational goods, and household furnishings prices. Select services prices include lodging away from home, airfare, and recreational services prices. These goods and services are separated to demonstrate cost factors that may be impacted by supply-demand and supply chain imbalances related to the COVID-19 recovery, including labor shortages in many service sectors. , as distinguished from housing, healthcare, and other services that may represent broadening inflationary pressures.
We expect supply chain bottlenecks and strong demand to keep inflation elevated at least through Q1 2022, before imbalances fade and inflation moderates over the second half of the year. Still, by the end of next year core personal consumption expenditure (PCE) inflation is likely to remain well above the Federal Reserve’s two percent objective. The timing of any “peak” in inflation pressures will have important implications for the path of monetary policy and related market outcomes.
Implications for monetary policy
Nothing in the December 2021 inflation data should dissuade the Federal Open Markets Committee (FOMC) from moving forward with plans to speed up the tapering of asset purchases.
A faster taper gives the Fed the option to raise rates sooner. Many economists and investors have pulled their rate liftoff assumptions forward in recent weeks, and we expect the Fed’s dot plot to show some adjustment as well.
The timing and pace of rate hikes depends on what inflation will do in the months ahead. If inflation peaks early in the year, the Fed may be able to hold out for more expansive labor market improvement. That said, we believe the bar for this outcome may be high. While labor market conditions have room to improve, they have recovered meaningfully in recent months and the unemployment rate may soon fall below 4.0%. This means that, as long as labor market improvement doesn’t halt, and if inflation remains near current levels, then the Fed’s hands may be tied.
For more on Fed policy, we recommend a read through MacKay Shields’ recent piece outlining why market risks may be skewed towards more tightening.
Economic and market risks
Increasing inflation risk has important implications. First is the real impact inflation has on household and business balance sheets. Absent commensurate adjustments (i.e. wage increases or price pass-through), purchasing and investment power can suffer as prices rise.
The second has to do with the policy response to inflation. Rate hikes may do little to improve supply chain bottlenecks, but they can help reduce demand pressure, thereby alleviating a key contributor to price increases. If the economy is on its way to overheating, this demand-reduction tactic could be constructive. A higher cost of capital can smooth the economic cycle without causing a recession, and slower-but-consistent growth is valuable for business and investment planning. The Fed is highly attuned to the economic risks of its policy stance, and would certainly prefer not to slam on the proverbial economic brakes. That said, this is a difficult “soft landing” to orchestrate.
Another major risk has to do with market volatility. For most of 2021, expectations around Fed policy were well anchored. The FOMC effectively communicated that tapering would begin at the end of 2021, and investors were broadly comfortable with high but “transitory” inflation. Now, over the course of several weeks, the arc of monetary policy has shifted. Investors should expect volatility in the level and curvature of interest rates as uncertainty prevails.