by Paul Hoffmeister, Chief Economist
Hawkish Fed minutes: 2% inflation goal reached.
Economy at or near full employment.
Philips curve logic to drive rate decisions.
On Wednesday, January 5, the FOMC released the minutes from its December 14-15 meeting, providing important insight into their views about the trajectory of monetary policy during the coming year. In our view, the minutes seemed especially hawkish, and their policy framework is somewhat concerning.
The Committee’s median projected timing for the first rate increase was pulled forward from Q1 2023 to June 2022, and many members believed that it was appropriate to start balance sheet runoff sooner after the initiation of the first rate increase than during the last rate-hiking cycle. Many believed it should transpire faster as well; in the previous cycle, the balance sheet runoff began almost two years after the policy rate lift-off commenced.
Note, at the time of the December meeting, the unemployment rate had declined from 4.8% in September to 4.2% in December, and core PCE price inflation (core personal consumption expenditures) had increased 4.1% year-over-year. Participants were generally constructive about the environment, with the minutes noting that “progress on vaccinations and strong policy support, indicators of economic activity and employment had continued to strengthen.”
With the relatively sanguine economic environment, some committee members noted that certain measures of inflation had reached decade-high levels and the percentage of product categories with substantial price increases continued to climb. Rising housing costs and rents, wage growth due to labor shortages, and supply constraints were also cited. Some participants expressed concern that “the recent elevated levels of inflation could increase the public’s longer-term expectations for inflation to a level above that consistent with the Committee’s longer-run inflation objective.”
To us, the following is one of the most important sections of the minutes:
Participants agreed that the Committee’s criteria of inflation rising to 2 percent and moderately exceeding 2 percent for some time had been more than met. All participants remarked that inflation had continued to run notably above 2 percent, reflecting supply and demand imbalances related to the pandemic and the reopening of the economy. With respect to the maximum-employment criterion, participants noted that the labor market had been making rapid progress as measured by a variety of indicators, including solid job gains reported in recent months, a substantial further decline in a range of unemployment rates to levels well below those prevailing a year ago, and a labor force participation rate that had recently edged up. Many participants judged that, if the current pace of improvement continued, labor markets would fast approach maximum employment. Several participants remarked that they viewed labor market conditions as already largely consistent with maximum employment.
Our interpretation of this is that a significant contingent of FOMC members believe that the economy is at or near full employment, and that inflation is excessive and must therefore be addressed. With inflation running at nearly 5% year-over-year and unemployment currently below 4% (near pre-pandemic levels), the Federal Reserve appears to be setting the stage for anti-inflation monetary policy in 2022. This means that it’s likely to pursue a prolonged rate-hiking campaign, which by definition seeks to limit economic growth.
While inflation is a major economic negative and can be pernicious in its effects, the Federal Reserve’s use of interest rates to modulate growth is arguably a poor tool to control inflation and has in the past led to major downturns that then required policymakers to backtrack on their respective rate increases. Furthermore, as clients have heard us say in recent years, we belive the view that too many people working is inflationary (and bad) is flawed. This framework of inflation is called the “Phillips Curve” and is highly disputed, and in our view, led to the excessively aggressive and mistaken rate hiking cycle of 2017-2018. Arguably, more people working and greater economic activity increases the demand for money and therefore can be deflationary.
Unfortunately, Phillips Curve-focused monetary policy is back.
As an aside, while we’re optimistic that currently high readings of inflation will abate over time, we believe that the Fed’s forecasts are too optimistic that they’ll hit their 2% inflation objective so quickly. The minutes stated: “PCE price inflation was therefore expected to step down to 2.1 percent in 2022 and to remain there in 2023 and 2024.”
We do not anticipate housing and energy-related prices to materially abate. As a result, a 2.1% PCE reading seems unlikely, in which case, this could only support inflation hawks on the Committee and the campaign for higher rates and a policy aimed at slowing economic growth at the margin. Is aggressive and perhaps misguided monetary policy a major, immediate macroeconomic risk? It may not be for the near-term. But this is something to closely monitor during the coming 12-24 months.
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Paul Hoffmeister is chief economist and portfolio manager at Camelot Portfolios, managing partner of Camelot Event-Driven Advisors, and co-portfolio manager of the Camelot Event-Driven Fund (tickers: EVDIX, EVDAX).
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