Team Transitory is throwing in the towel.
In a clear sign that the U.S. Federal Reserve is shifting to tighter monetary policy, Jerome Powell — who’s spent months arguing that the pandemic surge in inflation was largely due to transitory forces — told Congress on Tuesday that it’s “probably a good time to retire that word.”
The Fed chair, tapped last week for another four-year term, still thinks inflation will ebb next year. But in testimony before the Senate Banking Committee, he acknowledged that it’s proving more powerful and persistent than expected, and said the Fed will consider ending its asset purchases earlier than planned.
“It looks like the Fed wants to create some space to give them the option to raise rates well before the end of next year if they feel they need to,” said Brian Coulton, chief economist for Fitch Ratings Ltd.
Tightening credit before the jobs market has returned to the halcyon days that prevailed before COVID-19, when Black unemployment was at record lows and labor force participation was elevated, could invite criticism that the Fed is stepping away from the new monetary policy framework it adopted last year which was designed to ensure jobs gains that were broad-based and inclusive.
For markets, what Powell had to say about the two T-words — transitory and tapering — pointed in the same direction: policy makers are preparing the ground to raise interest rates much earlier than they’d anticipated just a few months ago, when the emphasis was on waiting until the economy was back to full employment.
How soon is that? After Powell’s remarks, money markets estimated a 50-50 chance that the Fed will hike as early as May, and they’re pricing in around 60 basis points of increases by the end of 2022. That’s more than they’d anticipated at the start of the day — but less than a week ago, before the world heard much about the new omicron strain of Covid-19, which poses fresh dangers to the economic outlook.
Not baked in
Powell cited that risk, and said “it’s not really baked into our forecasts” but didn’t dwell on it much. He was more concerned with spelling out the Fed’s latest thinking on prices and employment.
Since the reference to “transitory” inflation first appeared in the Fed’s policy statement in April, it’s been ever-present — and at the center of a fierce debate. Critics like former Treasury Secretary Larry Summers accused Powell and his team of downplaying the danger of a sustained bout of price pressures.
To hear Powell tell it, the problem with the “transitory” label was partly about messaging. While many in the markets saw it as suggesting that the Fed expected price pressures to be short-lived, Powell said policy makers intended it to mean that inflation wouldn’t become entrenched.
“The word ‘transitory’ has different meanings to different people,” he said. “We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation.”
‘What we missed’
But it’s about more than just messaging. The Fed misjudged the vigor of the inflationary impulses hitting the economy as it simultaneously opened up more fully after last year’s virtual shutdown while still dealing with the reality of an ongoing pandemic.
The personal consumption expenditures price gauge, which the Fed uses for its 2% inflation target, rose 5% in October from a year earlier.
“What we missed about inflation is that we didn’t predict the supply side problems,” Powell said.
Those snafus, from a shortage of microchips to a shipping squeeze, have ramped up costs for business and forced consumers to pay more for products they want that are in limited supply.
Powell said the Fed had also been caught out by the performance of the job market. Officials had expected Americans to flock back into the labor force after schools reopened in the fall and extended unemployment benefits had expired. That hasn’t occurred — at least so far.
The result has been a near record level of unfilled job openings, and bigger wage increases. U.S. employment costs rose at the fastest pace on record in the third quarter against a backdrop of widespread labor shortages.
The Fed is currently scheduled to complete its bond-purchase program in mid-2022 under a plan announced at the start of November. Policy makers will next meet on Dec. 14 and 15, when they could decide to speed up that timetable.
“This is a very abrupt pivot,” said Krishna Guha, vice chairman of Evercore ISI. “The likelihood that the Fed goes on to make a step-change in its rate plans is much higher than usual.”
Raising interest rates, though, would be far more consequential than ending bond buys. It would constitute a tightening of policy and an overt attempt to rein in the demand that’s helped the U.S. economy climb out of its coronavirus slump faster than most global peers.
Under the new monetary policy framework it adopted last year, the Fed said it would countenance inflation above its 2% target for a while to make up for past shortfalls, while also seeking to foster job gains that were broad-based and inclusive.
But Powell said it might take some time to return to the stellar jobs market that was in place before COVID-19, and that inflation would have to be brought under control in order to do it.
“To get back to the great labor market we had before the pandemic we’re going to need a long expansion,” he said. “To get that we’re going to need price stability.”
“The biggest change I saw in Powell was the lowering of the ceiling of the labor market,” said Derek Tang, an economist at LH Meyer/Monetary Policy Analytics in Washington. “Once that happens, the maximum employment door is open, so they can start talking about liftoff.”
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