Baby Steps – June 21, 2021

The red-hot economy and higher inflation haven’t gone unnoticed at the Federal Reserve, even after it kept its key short-term lending rate, the fed funds rate, unchanged last week. The Fed also said it would continue to purchase at least $120 billion in bonds each month. It did not release a plan to end or dial back the monthly bond buys.

Yet, there was a small but perceptible shift in the Fed’s stance. You see, when it comes to tightening policy, baby steps always seem to be the rule. For example, Fed Chief Powell said officials have started to discuss a plan to taper asset purchases. That’s right, just talk, no action.

The dot-plot thickens

More so, the Fed’s “dot plot” grabbed the attention of investors. The so-called dot plot is the Fed’s own set of projections for the fed funds rate through 2023. It suggests we could see two quarter-point rate hikes in 2023. Previously, the Fed projected it was on hold.

Still, even if the Fed were to raise the fed funds rate by a half-percentage point, it’s at least two years away, and short-term rates would still be at a low level.

That said, it all seems to be about inflation. Undoubtably, prices for some goods and services have jumped. It’s reflected in the Consumer Price Index. Yet, the Fed insists the surge is “transitory” and is tied to the reopening of the economy and supply chain bottlenecks.

What does transitory mean? Simply put, temporary, but the Fed hasn’t defined the parameters. Does temporary mean just a few months or a couple of years?

If we review the CPI over the last 100 years, four bouts of inflation jump off the page: World War I and II, a significant rise in prices during the 1970s, and the late 1940s, when pent-up demand and a shift to a peacetime economy caused a significant but transitory rise in prices.

It’s still too soon to say the Fed is right on its bet that the recent price spike is transitory, but it’s unlikely that Fed officials would tolerate the kind of rise in prices we saw post WWII.

If the Fed were to fall too far behind the curve, we might expect to see a faster pace of rate hikes to cool off consumer demand. What seems certain is that Powell is willing to tolerate a little hotter inflation as he hopes to encourage faster job growth and a return to full employment.

Created 2021-06-21 14:57:42