4 min read.Updated: 07 Sep 2021, 10:12 PM ISTLena Komileva
Will a policy shock in 2022 follow growth and inflation shocks?
The US Federal Reserve has met the historic challenge of navigating the world’s largest economy through a pandemic. But as the central bank prepares to reduce its covid stimulus, finding the next normal—for monetary policy, markets and the economy—will be its greatest test yet. In achieving a robust recovery, the latest round of quantitative easing (QE), fifth in the last decade, has seen the Fed’s balance sheet expand by some $4 trillion, equivalent to 20% of US gross domestic product, since March 2020.
Against this backdrop, the Fed’s cautious signalling toward ending QE at Jackson Hole achieved the seemingly impossible by not only preventing a repeat of markets’ 2013 ‘taper tantrum’, but by actually easing financial conditions, via lower real interest rates, higher stocks and a cheaper dollar. The policy pragmatism is well justified: By calming markets, the Fed has cleared the way for tapering its asset purchases.
The Fed’s strategic messaging is that it will be the economy, not policy, that will determine the path of real rates from here. Under its new, flexible average inflation targeting regime, policy is aiming for inflation that is ‘moderately’ above 2% for some time to compensate for past undershoots. This means lower real rates. To reach this target, the current policy guidance states that, even with US inflation averaging more than 5% in the last three months, the Fed is seeking “substantial further progress" toward full employment before scaling down stimulus. And only once the economy reaches maximum employment, with inflation sustainably at or above 2%, after QE has ended, will policymakers consider raising interest rates above the zero lower bound.
In other words, unless the economy overheats beyond full employment, with labour costs running ahead of productivity trends, the policy priority is to pursue a strong recovery via excess demand. The result will be more inflation in the pipeline.
The Fed’s real risk won’t be tapering, but timing. Acting too early to remove stimulus will harden covid scarring in labour markets, repeating the policy mistakes of the decade after the global financial crisis. But acting too late means more persistent inflation pressures will emerge, eroding household real incomes and corporate profit margins, and thereby shortening the recovery. Either way, the cost will be loss of Fed credibility and greater macro-financial volatility than markets currently expect. The trouble is, with new covid variants affecting growth, it will be a while before clarity emerges on the next post-covid normal.
On inflation, while markets now accept that much of the current overshoot is linked to temporary pandemic-related bottlenecks and supply imbalances, corporate anxiety about high costs is hot. Although today’s inflation may not last, an upward reset in wholesale price levels and housing costs is here to stay. This will act as a speed breaker for private investment—the very force needed to take over from fiscal expansion to support the economy’s covid healing.
Not that there is any sign that imbalances in the real economy will get resolved any time soon. While US GDP returned to its pre-pandemic level in the second quarter, labour markets remain disrupted. The pandemic has displaced more than 5 million US workers, or 3.3% of its labour force, but it has also shrunk the pool of available labour by 3 million, or 2%, since 2019. What’s more, the US working-age population (aged 15-64) is no longer growing. Workplaces also need ever more skills, given the tech adoption and corporate restructuring during the pandemic. These forces constrain labour supply and contribute to higher costs, just as the economy’s reopening fuels demand. Record US job openings in excess of 10 million and rising wage pressures signal that job markets are [rather tight].
For markets, the prospect of more Fed liquidity and lower interest rates is a short-term boon, thanks to lower discount rates and higher earnings reflation that lift asset prices and reduce credit costs. But the longer US Treasury yields diverge from the reality of stronger US nominal GDP growth, the greater the risk that Fed tightening will bring back bond and stock market volatility, capital losses as deeply negative real yield levels normalize, and weaker real asset returns amid higher inflation.
Again, the Fed is right to be stepping cautiously at the turning point of its policy cycle against the fog of covid uncertainty and economic disruption. The risk is that the US economy will surprise policymakers, on both the ongoing economic recovery and inflation, leaving policy on the wrong side of economic risks and markets (once again) on the wrong side of the policy calculus.
After the growth shock of 2020, and the inflation shock of 2021, markets will hope to avoid a policy shock in 2022. Easing them into a new or next normal will be the Fed’s toughest job yet.
Lena Komileva is managing partner and chief economist at G+ Economics.
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