On Jan. 11, Federal Reserve chairman Jerome Powell vowed to take far stronger steps than he’s so far signaled if high inflation persists. The next day, the Labor Department’s consumer price index report highlighted the scale of the Powell’s challenge: The CPI for December jumped 7% year over year, the sharpest spike since June of 1982, when the U.S. was still reeling from an OPEC-driven surge in oil prices. For markets and the economy, Powell’s bolder stance after months of dithering is extremely encouraging. He’s essentially pledging to do whatever it takes to wrestle inflation to the Fed’s target rate of 2%, though the task may take a while, and makes a reassuring case that nothing’s more essential to a healthy job market than stable prices.
“I wouldn’t say Powell is changing course just yet,” says William Luther, a monetary economist at Florida Atlantic University. “He’s looking to increase his options. If inflation gets out of hand, he’s carving the space to tighten more severely than it appeared in December, and a lot more than three months ago. His new position gives him the scope to pursue a tougher course if necessary.”
December inflation is highest yet
The jump of 7% in December’s consumer prices narrowly exceeded November’s 6.8% reading, and marked the seventh straight month that the CPI has risen by over 5% year over year. By New Year’s Eve, Americans were paying 0.4% more for food and an additional 0.5% in rent than just after Thanksgiving, while buying a new car or truck took a 3.5% bigger bite. In Powell’s opening statement at his nomination hearing before the Senate Banking Committee on Jan. 11, the chairman one again ascribed the headline-grabbing trend to temporary factors, stating that “the economy has rapidly gained steam despite the ongoing pandemic, giving rise to persistent supply and demand imbalances and bottlenecks, and thus to elevated inflation.” In other words, it’s the clash pitting the spending explosion stoked by generous COVID stimulus payments and families unleashing pent-up demand for the restaurant dining, travel, and cars they didn’t purchase earlier in the pandemic, against a shortage of the stuff they’re hungering for. That shortfall, of course, arises from supply-chain disruptions caused by plant shutdowns in China and other major exporters to the U.S., and the challenges to understaffed manufacturers and shippers here at home in restoring their operations to pre-pandemic levels.
A few months ago, Powell was predicting that the inflation virus would be over by now. Although he’s dropped the notorious “transitory” tag, and stopped giving a timeline for when the rising curve will flatten, it’s clear that Powell still believes the trend is temporary and will probably correct itself. The danger is that inflation that lasts month after month, even if at first sparked by short-lived forces, can take on a life of its own. If producers anticipate higher prices because they keep building month after month, they’ll put escalators into their long-term contracts, and workers will demand agreements incorporating big raises that put more cash in their bank accounts and contribute to pushing up prices. It’s reassuring that in his testimony, Powell sought to forestall a cycle of inflation breeding inflation by managing expectations. He did it by pledging to clinch the Fed’s 2% target, or close to it, at all costs.
Powell rejects the Phillips curve
In his testimony, Powell emphasized that stable, predictable prices––backed by the Fed’s pledge to ensure that regime––are crucial to a strong job market. “High inflation is a severe threat to the achievement of maximum employment,” he told the senators. That view contradicts a famous theory called “the Phillips curve,” stating that low unemployment is only achievable via high inflation, and that governments can only bring down inflation by creating lots of unemployment. “It’s wrong, but it’s a conventional view in the press and among commentators,” says Luther. In fact, Business Insider wrote on Jan. 11 that the Phillips curve has long been the Fed’s North Star. The article called the Phillips curve “one of economics’ most widely accepted concepts,” and went on to say that “the rule is a guiding light for the Federal Reserve, which is tasked with balancing price stability with maximum employment. It’s helped the central bank determine when to slash rates to stimulate the economy and when to hike them to cool inflation.”
But in reality, Powell doesn’t believe that high inflation is needed to fuel the job market. Just the opposite, in fact. “What Powell believes is that to create maximum employment, the U.S. needs a long expansion, and that’s only possible if we have stable prices,” says Luther. “He just stated to Congress that he doesn’t believe in the old Phillips curve tradeoff where low unemployment necessarily means higher inflation and higher unemployment breeds lower inflation. He believes that high rates of inflation cause more unemployment.” Luther states that almost all of the economics community discarded the Phillips curve concept decades ago. Hence, it’s not terribly surprising that Powell embraces the prevailing academic view.
Still, notes Luther, it’s great to hear Powell say so explicitly: “As a macroeconomist, I applaud what he said.” Otherwise, the perception among those who believe Powell has been too soft might be that he plans to hold rates extremely low in a campaign to stimulate the economy and create jobs. “To his credit, Powell’s saying no, no, no, to the idea that a strategy that tolerates high inflation creates more jobs,” says Luther.
Why inflation’s so bad for employment
Luther cites two reasons that high inflation slows growth and hence destroys jobs. The first is the time and money companies must devote to grappling with fast-rising prices. High inflation forces producers to change their wholesale and retail prices, and hence their advertising and promotions, far more frequently than in stable periods. They may need to hire experts and add systems to hedge purchases of supplies that whose prices change rapidly from month to month. “It gets worse the faster prices are rising,” says Luther. “Companies are using more and more resources to deal with inflation, leaving less for hiring workers and expanding their businesses.”
Second, volatile prices spread uncertainty that makes both companies and workers far more cautious. Luther notes that a person thinking of reentering the workforce won’t know how much in gas or groceries his or her salary will buy in the months ahead because prices are so volatile, or if they’ll get raises that keep up what could be soaring prices at the store and pump. “So they may decide that it’s not worth going back to work,” he says. “If they stay at home, they’ll save money by not hiring a babysitter. If there’s a lot of uncertainty over what their dollars will buy going forward, they may not take the risk of going back to work.”
Likewise, companies become much more reluctant to embrace long-term contracts that give them clear visibility on their future costs. Suddenly, the prospects of doing those agreements go from comforting to scary. Suppliers of aluminum siding or semiconductors fear agreeing to fixed prices a year or two in advance because they don’t know what their own costs will be that far forward. In periods of heavy inflation, they could take a big loss on those agreements––or bank a windfall if what they’re paying for materials suddenly drops. A producer can’t predict if the prices they can charge a year hence will cover the big escalator their supplier is demanding. If an inflationary mentality takes hold, and producers sign those deals en masse, they’ll also try to raise their own prices en masse, leading to a cycle of increases that builds on itself.
Inflation also swells interest rates, discouraging companies from borrowing. Companies pay higher carrying costs on loans to build plants or fabs, but they are unsure if they can raise prices fast enough to make the increased cost of debt a good deal. “On the margin, businesses thinking about expanding are less likely to do it in inflationary periods, in part because of their reluctance to borrow and enter into relatively secure long-term contracts,” notes Luther. “They may take the view, ‘Let’s wait until inflation comes down to pursue the project.’” Those risks curbs economic growth and stymies job creation.
For Luther, the best solution is for Powell to follow what he suggested in his recent nomination testimony: anchor expectations that high inflation won’t last because the Fed’s dead set on taming it. That would encourage companies to enter into purchase agreements that don’t include big inflation increases that can become a self-fulfilling force, and pursue new projects with confidence that their costs and the prices they charge will rise at a steady, predictable rate in the years ahead.
What is the Fed’s goal for ‘maximum employment’?
As Powell noted in his testimony, though the labor market is recovering, the U.S. needs to add a lot more jobs to get to the Fed’s statutory goal of “maximum employment.” Just prior to the pandemic, America boasted 149 million nonfarm jobs, an all-time record. Although the jobless rate hit a seemingly impressive 3.9% in December, the economy added a disappointing 199,000 positions, less than half the expected increase. And a total 3.6 million fewer Americans are now working than in February of 2020, marking a 2.3% fall in the employment rolls.
So what’s the job deficit the Fed’s policies must fill to reach maximum employment? Luther points out that owing to our aging population, payrolls were destined to decline from pre-pandemic levels just for demographic reasons, even if the economy had kept going gangbusters. Still, the COVID-driven recession made the slide much steeper than the gradual decline already in the cards. Many older workers laid off in the pandemic chose to retire instead of seeking new jobs. Mothers and fathers opted for lower family income by leaving the workforce, staying home instead to care for their kids and their health.
“Powell probably sees maximum employment somewhere between what was projected for today before the pandemic, which was already lower than the 2020 numbers, and where the numbers are now,” says Luther. Getting a couple of million Americans back to work is a big job. For Powell, achieving the low inflation that gives companies comfort to expand and hire is the only path to success.
The markets are betting on the Fed
Although Powell deserves kudos for the stronger stance unveiled at the hearings, he’s stepping up late. And that makes his task much harder. “The Fed recognized inflation much later than it should have,” says Luther. “They’re taking steps beyond mere words a lot later than they should have.” In November, Fed officials were split between predicting one and no rate hikes in 2022. Now, they’re foreseeing three and possibly four one-quarter point moves this year, a course that would lift the Fed funds rate from near-zero to 0.75% or 1.0%. Powell says he’s willing to do even more. “If we have to raise interest rates more over time, we will,” he declared at the nomination hearing. It’s all part of his call to ready Congress and the markets to the possibility of a much stronger squeeze in the months ahead than his statements suggested less than a month ago.
Today, the Fed is predicting inflation that looks low by the recent monthly figures, but is still way above the 2% goal. The central bank’s forecast calls for increases of 2.6% this year, 2.3% and 2.1%, respectively, for 2023 and 2024. The markets see higher numbers over the next few years, though not alarmingly so. The five-year Treasury break-even rate that expresses the difference between the five-year notes and rate on Treasury Inflation-Protected Securities, or TIPS, forecasts average inflation of 2.82% through 2026, which exceeds the Fed’s numbers even after accounting for differences in measures their respective measures of inflation. The good news is that the 10-year break-even posits price increases of just 2.48%. That means investors are betting big money that inflation will be far more modest from 2027 to 2032 than in the next half-decade, more like 2.2% in those out-years.
That would get us close to the Fed’s target, but gradually so. The markets think that the current inflation rampage will indeed heal itself, and that the Fed will do the right thing if it persists longer than expected. But investors don’t think the U.S. has a structural problem. Inflation in the high twos for the next few years isn’t as good as inflation at 2% or even lower, and the Fed’s tardiness is to blame for putting the economy in that bind. But prices would still be steady enough to sustain a strong economy that can restore the jobs lost in the pandemic, especially because the markets expect price increases to trend downward as the decade progresses. Powell’s late but welcome new shift inspires confidence that the economy’s hobgoblin won’t keep haunting us for long.
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