When the Federal Reserve last year laid out a new mantra for monetary policy, conditions in the US economy were so poor that the dovish shift was expected to guarantee ultra-easy money for years to come.
But the likelihood of additional large-scale fiscal stimulus under President Joe Biden and a possible jump in inflation is now increasing pressure on the US central bank to signal how and when it might start dialling back its monetary support.
“At some point, they will have to acknowledge [the looming fiscal support] and incorporate it in their forecasts,” said Aneta Markowska, chief financial economist at Jefferies. “It does improve growth prospects, and because they said they would be data dependent, it does potentially accelerate the timeframe for normalisation. That’s going to be a balancing act.”
Jay Powell, the Fed chairman, will have an opportunity to discuss the brighter outlook and its implications for policy when he speaks on Wednesday to the Economic Club of New York about the state of the US labour market.
Along with signs of bubbles in asset prices, the new economic terrain will test the more dovish policy paradigm — including higher tolerance for inflation and a more dogged commitment to achieve full employment — that the Fed introduced in the second half of last year based on lessons from the past decade.
“As the economy improves, but before you get any data that says you are close to your goals, that’s the pressure point for Powell and the Fed in general,” said Tim Duy, a Fed watcher at the University of Oregon.
Over the course of the pandemic, Powell has been consistently downbeat, stressing the downside risks to the recovery, the potential for long-term scarring of America’s workforce and businesses, the prevalence of disinflationary pressures and the need for further fiscal support.
Powell also has set a very high bar for tightening monetary policy, with the Fed issuing guidance it will not raise US interest rates until inflation is on track to rise above 2 per cent and full employment is reached according to broad measures of the labour market. Even a reduction in the pace of asset purchases — or tapering — would require “substantial further progress” towards those goals, the Fed has said.
For now, the economy remains far from those objectives, and the picture is still grim. The US economy generated a paltry 49,000 jobs in January, and remains almost 10m positions short of its employment levels before the pandemic. Moreover, the recent drop in the jobless rate, to 6.3 per cent, was driven by thousands of Americans leaving the workforce entirely, discouraged about their chances of finding employment.
The last reading on the Fed’s preferred measure of inflation — the core personal consumption expenditures index — was still 1.5 per cent in December, well short of its target, and central bank officials have stressed that any spike in inflation could be transitory. The economy could also produce negative surprises, due to a disappointing pace of vaccinations, the spread of dangerous coronavirus variants or a failure to pass the $1.9tn stimulus plan offered by Biden and now being debated in Congress.
There was also no sign of inflationary pressures in January. The core consumer price index was flat compared to December and up just 1.4 per cent compared to January 2020.
But most economists have grown increasingly confident that significant improvement is around the corner, setting the stage for a reckoning with a new reality at the US central bank. At its December meeting, the median Fed official expected output to grow by 4.2 per cent this year, with interest rates close to zero until at least the end of 2023. But those projections are likely to be more optimistic at the next meeting in March.
“We expect increased vaccinations, stable household finances — supported by increased fiscal transfers and elevated savings — and robust business and housing sector activity will lead to real GDP growth of 5.9 per cent in 2021,” Gregory Daco, chief US economist at Oxford Economics, wrote this week, pointing to a “summer mini-boom” ahead. Daco added that he now expected the Fed to start curbing asset purchases early next year and to start increasing rates in mid-2023.
Speaking this week, at least two voting members of the Federal Open Market Committee remained cautious about the state of the economy and shrugged off concerns about an inflationary spiral, which were partially triggered by a critical assessment of Biden’s stimulus plan by Lawrence Summers, the Harvard University economist and former US Treasury secretary.
“I’m really not expecting us to see a spike in inflation that is very robust in the next 12 months or so,” Raphael Bostic, the president of the Federal Reserve Bank of Atlanta, said at a Washington Post event on Monday. “There’s so much uncertainty. I’m not precluding it, but it’s just not what I’m expecting right now,” he said, adding that he was factoring in “steady and slow” progress in the economy rather than a sharp acceleration.
Tom Barkin, the president of the Federal Reserve Bank of Richmond, told the Financial Times he expected “short-term price volatility” but stressed that he saw deflationary as well as inflationary risks on the horizon. “I’m keeping my focus on medium-term [inflation] expectations,” Barkin said.
Such comments have reinforced the notion that the brighter outlook alone is unlikely to cause the Fed to send any signals that it is moving away from its extraordinary monetary support.
Duy noted that one of the foundations of the central bank’s new approach to policymaking is that it will only shift its stance based on “realised outcomes” — meaning actual macroeconomic results.
One of the potential pitfalls in the Fed’s patient approach would be responding to suddenly higher inflation, a prospect raised by Summers, which could force the central bank to engineer a hard landing for the economy, unsettling markets and stoking internal tensions.
However, Janet Yellen, the Treasury secretary and former Fed chair, responded on the news channel CNN: “I can tell you we have the tools to deal with that risk if it materialises.”