Speeches Highlight Fed Predicament

Two speeches by Vice Chair Clarida and Governor Bowman, who represents community banking at the Board, highlight the predicament the Fed is in.

Clarida’s speech at a Brookings panel basically followed the familiar FOMC script: mid-year taper completion, end-2022 unemployment at 3.8% below the FOMC estimate of U* at 4%, liftoff by end-2022. At the same time Clarida added: “Realized PCE inflation so far this year represents, to me, much more than a “moderate” overshoot of our 2 percent longer-run inflation objective, and I would not consider a repeat performance next year a policy success. Second, as always, there are risks to any outlook, and I and 12 of my colleagues believe that the risks to the outlook for inflation are to the upside.” 

But if inflation is too high and risks tilted to the upside, it would be inconsistent for the Fed to wait until end-2022. Clarida’s/the FOMC 2022 GDP forecast, 3.8%, is inconsistent with their end-2022 unemployment at 3.8% and rather suggests a much lower unemployment rate. For instance, assuming that the past 3 months average NFP, about 450k continues, and that participation remains flat, the US unemployment rate would fall to 4% in January. Please see my discussion here.

What adds to the constraints faced by the Fed is that it wants to complete taper before hiking. At the current pace taper will end in June. So, a Fed that is concerned by upside risks to inflation won’t be able to hike until 6m after the US has hit full employment. The bottom line is the Fed is still buying more than $100bn in securities monthly when inflation is at 4 ½%. Whether inflation is transitory or not, no central banker wants to find itself in that position. That is why I am expecting a December announcement of a faster taper starting in January.

Clarida’s panel was followed by a panel on his panel that included former NY Fed president Dudley. Dudley stated that the Fed was behind the curve, that accelerating the taper would elicit a negative market reaction, but the Fed had no choice but to engineer a marked tightening of financial conditions to contain inflation. He further said that the Fed would not be able to engineer a soft landing next year as it would be tightening policy to slow down inflation and that had never been accomplished with a soft landing.

I agree with Dudley on hard landing, especially since I don’t think that inflation is that much of a risk and that the Fed will be overtightening in a supply shock. A second speech this morning by Governor Bowman highlights how difficult it will be to finetune monetary policy. Bowman is concerned that mortgage servicing has moved away from banks and into non-bank mortgage companies that are state supervised and don’t have access to Fed liquidity. In 2020 the introduction of forbearance did not impact servicers liquidity because house prices were going up and borrowers were able to refinance which supported servicers liquidity.

Bowman however is concerned by the risks of a decline in house prices (median existing home prices have been falling for the past 4 months) as CPB imposed limitations on foreclosures expire at end-2021 and about 1mn borrowers will exit their forbearance programs in January. This time around servicers may not fare well, especially if house prices are falling or mortgage rates rising. Bowman concerns echo Ivy Zelman’s over the fragility of the real estate market. In her view the 30 yr mortgage rate rising above 4% would bring demand to a halt (30 yr rates are about 3.2%).

Is the Fed really concerned by inflation? If so, it is bound to act accordingly.

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.

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