Inflation risks could trigger tight Fed policy

A risk-management approach to unexpectedly high US inflation suggests that a fast return to neutral funds rate – 2½% on the Fed’s calculation or about 2% on market pricing – is prudent given the risk the Fed might need to adopt tight policy. A simple model shows that most of the recent sharp pick-up in inflation reflects pandemic disruptions, which extend to the labour market, where there has been an unprecedented reduction in the supply of labour. Inflation should ease as these disruptions abate later this year – which is consistent with market pricing of a broadly neutral policy rate and bias-adjusted measures of market inflation expectations – although the labour market should add slightly to inflation as unemployment falls below the NAIRU. Short-term inflation expectations have risen in line with actual inflation, but long-term measures remain anchored. If long-term expectations became unmoored, the Fed would need to react aggressively. In such a scenario, the slope of the yield curve would be the most reliable indicator of the risk of eventual recession.

Over the past year or so, several advanced economy central banks have started to unwind the emergency policy stimulus implemented at the height of the pandemic. Unconventional policy has often been adjusted first, with central banks either buying government bonds at a slower pace or stopping buying altogether. In the case of conventional monetary policy, some central banks have started to take back the emergency rate cuts of 2020. 

The Federal Reserve has signalled it will follow suit next month, stopping buying bonds and raising its policy rate for the first time since 2018. The Fed will update its forecasts at the March FOMC meeting, but the futures market is currently factoring in a series of hikes with the funds rate peaking at about 2% in 2023 before edging lower over 2024 and 2025 to 1¾%. 

This peak in interest rates is below the FOMC’s median estimate of a 2½% neutral funds rate, but within the 2-3% range of FOMC member estimates, also matching the NY Fed’s pre-pandemic model estimate of 2%.     

The catalyst for the earlier-than-anticipated rate rises has been the unexpectedly rapid acceleration in US inflation over the past year. For example, the Fed’s preferred measure of underlying inflation – the core PCE deflator – has increased by about 4½% over the past year, which is not only the highest inflation rate since the early 1980s, but the fastest core inflation among the large advanced economies. 

Market pricing of the funds rate returning to a broadly neutral level indicates that most investors believe this surge in inflation is temporary, easing as pandemic-driven disruptions fade, in line with Fed estimates of bias-adjusted market expectations of inflation. 

In this scenario, neutral policy would be consistent with the Fed achieving a “soft landing” for the economy, comprising broadly full employment and inflation returning to the Fed’s 2% target.  

Given the uncertainty around whether high inflation will continue, the prudent approach for the Fed would be to quickly increase the funds rate to a neutral level, placing it in a better position if it needs to adopt tight policy. 

Although the pandemic is very different to a usual economic cycle, history supports the view that taking out insurance by achieving a neutral funds rate would be the best course of action. That is, using the New York Fed’s model estimate of the neutral rate as a benchmark given its long history, the funds rate rarely spends much time at neutral and policy is often either loose or tight for extended periods. 

In fact, it is common for Fed tightening cycles to end in recession, sometimes by accident, but sometimes by design to rein in inflation. This is partly because a central bank confronted by high inflation has to be aggressive in raising rates in order to raise the real policy rate, while the Fed’s own research shows that inflation is not particularly sensitive to higher rates, with a 100bp increase in the funds rate reducing inflation by an estimated 0.35pp.  

The risk of tight monetary policy largely rests with whether high inflation becomes entrenched in the US. This most obvious way this could occur is if COVID-driven supply-side disruptions continue, such that producers and distribution chains are unable to keep up with the demand for goods. Another way is if the economy overheats and the unemployment rate falls below the NAIRU. Finally, high actual inflation could feed into high expected inflation, where long-term expectations anchor future inflation.

In order to judge these risks, we estimated a simple Phillips curve equation that specified:

• Core PCE inflation = expected inflation + a*(unemployment rate – NAIRU) + supply factors

where:

• Expected inflation = the Fed’s “index of common inflation expectations” (or CIE), which summarises the common trend across a large range of measures of expectations of households, firms, professional forecasters and investors;
• NAIRU = the median FOMC estimate of the NAIRU; and
• Supply factors = the New York Fed’s “global supply chain pressure index”, which distils information from global business surveys, shipping rates and air freight costs.

The model suggests that nearly all the acceleration in quarterly inflation over the past year reflects supply-chain problems, although the model cannot account for all the pick-up given it explains – a still‑respectable – 45% of the variation in inflation. A tighter labour market has also contributed slightly to higher inflation as the rapid decline in the unemployment rate has seen it become less of a drag on prices as it quickly approaches the NAIRU. Inflation expectations – anchored by relatively stable long-term expectations – have not had an appreciable effect on actual inflation.  

Inflation is likely to slow in the second half of this year as supply-side disruptions recede. There are already some indications that supply pressures have broadly peaked; for example, there has been a small decline in semiconductor prices and a partial rebound in vehicle production and sales, where a huge rise in motor vehicle prices has been the most prominent example of the impact of supply disruptions on inflation. 

However, the disruptions could take longer to abate than expected and may even intensify if another COVID variant emerges. This risk is underscored by the still-high world-wide number of deaths from COVID.  

And inflation pressures will be further amplified in the immediate term by the war between Russia and the Ukraine, and the striking impact of this event on, amongst other things, commodity and wheat prices.

With a massive monetary and fiscal stimulus greatly limiting the scarring of the labour market from the pandemic, the unemployment rate in the US fallen from a peak of 15% in 2020 – which was the second-highest level in modern history – to about 4%.  

This is a remarkable achievement, particularly when the unemployment rate often never regains its pre-recession level by the time the next recession rolls around and if it does it typically takes about four years. 

This means that the unemployment rate now broadly matches the FOMC’s median estimate of 4%, such that the labour market is no longer a drag on inflation. This has added slightly to inflation as the economy has recovered and should add more assuming that unemployment soon falls below 4%.    

Although the simple Phillips curve model relies on the gap between the unemployment rate and the NAIRU to capture the influence of the labour market on inflation, a rapid pick-up in wages growth raises the question of whether the gap is an adequate measure at present. For example, the Atlanta Fed’s measure of the median hourly wage is up almost 6% over the past year, which is the fastest wages growth since 2000. 

However, the acceleration in wages growth seems mostly driven by a substantial contraction in the supply of labour, where many workers who either lost their job or gave up looking for work during the pandemic have yet to return to the workforce. This is partly because government support during the pandemic did not retain the link between employers and stood-down staff, but also because many people are worried about the risk posed by COVID to them and their families. 

This supply shock has eased a little recently, but unless it is reversed it points to a large one-off lift in wage rates.

The more serious risk to inflation is if high actual inflation feeds into higher expected inflation. To date, short-term measures of expected inflation have moved in synch with the pick-up in actual inflation. However, the Fed’s index of inflation expectations, which gives a larger weight to long-term measures of inflation expectations and is the series we used in the simple model of inflation above, is still close the Fed’s 2% inflation target. 

The 1970s showed how long-term inflation expectations can become unmoored, entrenching extremely high inflation, although that happened over several years, driven by persistently loose policy and two oil price shocks. If there were signs that long-term expectations were trending higher, that would automatically trigger an aggressive interest rate response from the Fed.

In a central forecast scenario, the Fed would raise the policy rate to a neutral level as inflation subsides later this year when pandemic disruptions moderate. 

However, there is a clear risk that inflation stays high for longer than anticipated for the reasons outlined above.  In such an upside scenario, the Fed would adopt tight monetary policy, leading to a risk of eventual recession. 

If that scenario were realised, analysis suggests that the most robust way to assess the risk of recession is to rely on the slope of the yield curve, albeit where the results are enhanced by adding the level of the Federal funds rate, such that an inverted yield curve matters more if it occurs at a higher level of interest rates. 

The yield curve does not always give strong signals of recession, but beats stock prices, which are its nearest competitor, where equities overpredict the occurrence of recessions. 

Estimating a simple model of the risk of recession in a year’s time based on the slope of the yield curve and the level of the funds rate, the model suggests that the risk is currently very low at about 5%. 

This is not surprising as the market is only factoring in a return to a broadly neutral level of the cash rate. As the Fed raises rates, the model’s estimated odds will increase. If short-term rates rise high enough and the yield curve inverts, model odds of 30‑40% have been associated with the past four recessions. 

Although the yield curve has the best track record of any economic or financial indicator in signalling the risk of recession, there is the possibility that unconventional monetary policy is distorting the signal at the margin. This is because the Fed’s enormous quantitative easing (QE) programme has reduced bond yields and quantitative tightening (QT) will work in reverse. Depending on the size and scale of QT as the Fed raises interest rates, this will reduce the model’s recession estimates at the margin.