A still-dovish Fed raises the risk of stagflation lite

The Federal Reserve Open Market Committee (FOMC) recently announced that it will gradually taper its $120 billion a month asset purchase program. Fed Chairman Jerome Powell, however, continued to stress that policy rate increases will not occur until the labor market is fully healed. The relatively slow pace of tapering along with the delayed initiation of rate hikes raises the prospect of the U.S. experiencing a “stagflation lite” shock (involving a growth slowdown amid persistently high inflation). 

Robust consumer demand (supported by strong household balance sheets, improving labor market conditions and a sharp decline in daily new COVID-19 cases and deaths) and a strong corporate investment outlook suggest that healthy aggregate demand levels are likely to be maintained for the foreseeable future. But widespread labor shortages, global supply chain woes and surging energy prices have created a perfect storm on the aggregate supply front.

The pandemic shock resulted in a dramatic shift in consumer spending behavior — a sharp spike in demand for durable goods of various kinds that has persisted as the wait for a full recovery in services continues. Global supply chains have been unable to meet the unexpected and sustained surge in durable goods orders. 

The Fed’s initial assumption that inflationary pressures will prove to be a mostly transitory phenomenon appears increasingly at odds with reality. Resolution of supply-chain bottlenecks and reorientation of production capacities will take some time. Even a top Fed official is now recommending that the central bank abandon the use of the term “transitory” to describe current inflation dynamics. 

There are several reasons for the Fed to take recent inflationary developments more seriously. First and foremost, the risk of a wage-price spiral is no longer a theoretical curiosity. There is a distinct possibility that the U.S. full-employment level has shifted and, consequently, trying to run a high-pressure economy in order to bring unemployment rates down to their pre-pandemic lows will prove to be highly inflationary. 

Furthermore, the Fed’s hard-earned credibility is genuinely under threat for the first time in decades. Former Minneapolis Fed President Narayana Kocherlakota recently expressed concerns even about the Fed’s political independence: “The Biden administration has yet to signal whether it plans to appoint Chair Powell to a second term when his current one runs out in February,” Kocherlakota wrote in an op-ed. “If Powell wants reappointment, it might behoove him to curry favor with the administration and its left-wing critics by keeping monetary policy loose.” 

Monetary theory ascribes a significant role for central bank credibility. As former Richmond Fed President Jeffrey Lacker once noted: “If a central bank’s record in fighting off higher prices is weak, shocks that hit the economy can easily unhinge inflation expectations and push the inflation rate upward. By contrast, if a central bank’s credibility is well-established, people are less jittery about every piece of news that can affect future inflation, making it easier for the central bank to pursue price stability.”

Any diminution of the Fed’s credibility would raise the future cost of bringing inflation back under control. Bond markets are still subscribing to the view that inflation hawks will win the argument within the FOMC and that the U.S. central bank will be forced to raise rates starting in the middle of 2022.

In fact, the recent inversion of the long-end of the U.S. Treasury yield curve (with 30-year yields falling below 20-year yields) suggests that bond market participants expect future rate hikes to dramatically cool the economy. Given the current dovish stance of many FOMC members, the bond market may be in for a rude surprise.    

The Fed’s rationale for adopting a wait-and-see approach was provided in a recent speech by Fed Governor Randal Quarles. He noted: “The fundamental dilemma that we face at the Fed right now is this: Demand, augmented by unprecedented fiscal stimulus, has been outstripping a temporarily disrupted supply, leading to high inflation. But the fundamental productive capacity of our economy as it existed just before COVID – and, thus, the ability to satisfy that demand without inflation – remains largely as it was, and the factors that are disrupting it appear to be transitory. Looked at purely in that light, constraining demand now, to bring it into line with a transiently interrupted supply, would be premature.”

Given that robust demand is expected to persist in the near-term, and given that U.S. and global supply-chain bottlenecks and labor market disruptions will take months (if not years) to be fully resolved, the real risk is that the Fed is already behind the curve and that it will require a lot more rate hikes than financial markets expect to bring rising inflation expectations under control. This could lead to potential financial market turmoil and create significant economic headwinds.

If supply shortages and persistent upward pressure on prices continue to pose challenges well into 2022, some demand destruction may be inevitable. Hence, the rising concern regarding the possibility of a “stagflation lite” shock. There are already signs that inflation fears are starting to affect public morale.

A potential wildcard in the ongoing inflation debate is the rate of productivity growth. If a surge in capital spending and rapid adoption of technology-based solutions to deal with labor shortages led to a long-awaited uptick in labor productivity, then inflationary pressures will ease. There is, however, considerable uncertainty associated with both the pace and extent of future productivity gains. At present, wage growth is outpacing productivity gains, and contributing to inflationary pressures.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.