Powell Pivots

The Federal Reserve and Fed Chief Powell are finally coming to grips with the idea that inflation may be a bigger problem than it initially expected. Out is the word “transitory” to describe surging prices. In is the idea that the Fed must take a stronger approach.

On Wednesday, the Fed announced it will reduce the amount of bonds it buys by $30 billion per month starting in January, double the pace it announced at its November meeting.

At the current pace, bond buys will end in March rather than June, possibly teeing up the first rate in May, or perhaps March, as one Fed official said, according to the Financial Times.

Ending the purchases earlier gives the Fed more flexibility to raise interest rates sooner.

The Fed’s Economic Projections suggest as much. In 2022, the Fed projects three, 0.25-percentage-point rate hikes, versus just one at the September meeting. That would place the fed funds rate at 0.75-1.0% versus today’s range of 0.0-0.25%.

Powell’s comments during his Wednesday press conference were an attempt, at least in part, to reassure investors and not rattle markets. It was not as aggressive as some had expected. The $30 billion taper and forecast of three rate hikes next year were generally in line with expectations.

Still, emergency stimulus introduced at the beginning of the pandemic continues. Given the jump in inflation, the Fed could have acted more aggressively. It didn’t.

Or it could have acted sooner. It hasn’t.

When asked if he believes the Fed is behind the curve on inflation, Powell responded, “The risk of higher inflation becoming entrenched has increased,” (but) “I don’t think it’s high at this moment, but I think it’s increased.”

Maybe it’s not entrenched, but the Fed’s credibility on inflation has come into question after repeatedly emphasizing that it expected the initial burst to be temporary. Note the Fed had projected 1.8% inflation as 2021 was about to begin—table above.

A fear in some corners is that this year’s supply chain hiccups, which have influenced inflation, might be replaced next year by a wage-price spiral. In other words, labor shortages and higher prices lead to higher wages, which force businesses to pass along the higher costs.

Today, Fed officials don’t see that. Just the opposite, they expect inflation to slow significantly next year. But the big miss in 2021 has undermined their credibility.

Over the near term, investors are digesting the less dovish stance and balancing it with the prospect that profit growth will remain strong.

If you have any questions or would like to discuss any other matters, please let me know.

Warmest regards and best wishes for a Merry Christmas to you and your family!