Far Too Soon to Lift the Dots
- By Dominique Dwor-Frecaut
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- 3 min read
The April CPI of 0.9% MoM against the expected 0.3% MoM was a huge surprise. Predictably, the Fed stressed that the data was noisy and likely reflects temporary, re-opening-induced imbalances between supply and demand. The market largely ignored that. It started to price more rate hikes, and bonds and equities sold off. I think it is far too soon to worry about inflation or Fed tightening.
The Fed is unlikely to move until confident that the higher inflation prints are the beginning of a trend rather than transitory. Not doing so would effectively end the implementation of the average inflation targeting (AIT) framework adopted in August 2020. And assessing how temporary higher inflation is will take time, likely well into 2022, due to current supply-side constraints and the very large economic slack (Chart 1).
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Summary
- Markets reacted to the very large CPI surprise by pricing a higher policy rate trajectory and selling equities and bonds. I think this is far too soon.
- More outlier inflation prints are likely. But we will not know whether they are one-offs or the beginning of a trend for a few quarters.
- Meanwhile, the Fed will talk back market pricing of the dots, likely with some success. Market fears of inflation could be more difficult to contain.
Market Implications
- Steeper curve
The Fed Will Wait Until Well Into 2022 to React to High Inflation Prints
The April CPI of 0.9% MoM against the expected 0.3% MoM was a huge surprise. Predictably, the Fed stressed that the data was noisy and likely reflects temporary, re-opening-induced imbalances between supply and demand. The market largely ignored that. It started to price more rate hikes, and bonds and equities sold off. I think it is far too soon to worry about inflation or Fed tightening.
The Fed is unlikely to move until confident that the higher inflation prints are the beginning of a trend rather than transitory. Not doing so would effectively end the implementation of the average inflation targeting (AIT) framework adopted in August 2020. And assessing how temporary higher inflation is will take time, likely well into 2022, due to current supply-side constraints and the very large economic slack (Chart 1).
More outlier inflation prints are likely this year, and core PCE could end up above the FOMC end-2021 forecast of 2.2% YoY. This alone would be insufficient for the Fed to lift its dots.
Higher Inflation Expectations Are Unlikely to Suspend AIT Implementation
Even before the release of the April CPI, inflation expectations were rising. More than a high CPI print, this development could lead the Fed to lift the dots. That is because the Fed views inflation as a series of deviations around a long-term trend driven by inflation expectations. Also, because expectations are sticky and the Phillips curve is fairly flat, should they become de-anchored, bringing them down would require significant output and employment losses. Since the Fed adopted the new AIT framework last August, FOMC members have repeatedly stressed that ‘our policy will aim to achieve inflation outcomes that keep inflation expectations well anchored at our 2% longer-run goal’.
In a January speech, Vice Chair Richard Clarida further indicated that he closely followed the Fed staff Index of Common Inflation Expectations (the CIE index is updated quarterly on the Fed website and available on BBG, CIEFED index). He stressed that ‘Other things being equal, my desired pace of policy normalization post liftoff to return inflation to 2% would be somewhat slower than otherwise if the CIE index at the time of liftoff is below the pre-ELB level.’ The CIE pre-ELB level is the level prevailing before December 2008 when the Fed Funds rate hit the zero limit for the first time, or about 2.1%.
But if the CIE moved above its pre-ELB level, would the Fed tighten faster? The CIE has strongly rebounded from its mid-2020 lows and, on current trends, could return to the pre-ELB levels by mid-2022. Such a trajectory could form a policy dilemma for the FOMC since the CIE (and most measures of inflation expectations) tends to be more correlated with oil prices than with actual inflation or economic slack.
It seems to me that the Fed has too much credibility at stake to react to a sharp increase in the CIE should actual inflation still be below 2%. Instead, since the CIE is a slow-moving variable, a continued rise could see the FOMC refocus its monitoring of inflation expectations to a broader set of indicators. For the Fed to lift the dots, a reappraisal of the trajectory of actual inflation, rather than of inflation expectations, is necessary.
Market Consequences
I expect greater market confidence in the Fed’s dovishness than in inflation trends, which could make for a steeper curve.
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Dominique Dwor-Frecaut is a macro strategist based in Southern California. She has worked on EM and DMs at hedge funds, on the sell side, the NY Fed , the IMF and the World Bank. She publishes the blog Macro Sis that discusses the drivers of macro returns.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)