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June 16, 2021

A Shift in Emphasis, For Now

By John L. Bellows, PhD

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The US economic data has surprised in both directions since the previous Federal Open Market Committee (FOMC) meeting. The employment data has been surprisingly weak. Fewer than 300,000 jobs were added in April, followed by a slightly better but still disappointing 550,000 jobs in May. The inflation data, on the other hand, has been surprisingly strong. Two successive months of above-consensus prints have taken core CPI inflation to 3.8% year-over-year, its highest level in nearly 30 years. The discussion at today’s FOMC meeting likely centered on which of the two was the more consequential development.

The FOMC appears to have decided that the inflation surprises were more important, at least for the moment. Accordingly, as one might expect from a committee focused on upside inflation risks, the changes in the FOMC communications generally took on a more hawkish tone. The FOMC forecast for Core Personal Consumption Expenditures (PCE) inflation in 2021 increased to 3.0% (up from 2.2% in March). The median FOMC member also pulled forward her forecast for the first rate hike, so that now the median participant expects two hikes in 2023 (in March the median FOMC member forecast that the first rate hike wouldn’t come until 2024). Making this movement in forecasted rate hikes all the more striking was that forecasts for inflation in 2023 did not change. The implication is that the current period of high inflation, rather than an expectation of higher inflation in the future, motivated the movement toward tighter forecasted policy.

With regard to the discussion around inflation, Fed Chair Jerome Powell reiterated his long-held view that the current surge in prices will most likely be transient, especially as a large share of the recent upside surprises are due to reopening and supply chain bottlenecks. He also noted the possibility that the dynamics that had been putting downward pressure on inflation—he mentioned an aging population and globalization, among other factors—may again reassert themselves after the pandemic. Powell may end up being right on his forecast (and, for the record, we think the odds are in his favor), but the recent surprises have been large enough that the FOMC needed to make some adjustments in the meantime.

While the emphasis appears to have been on the inflation data, the FOMC did not completely ignore the disappointing labor market data. Chair Powell had previously said he expected “a string” of strong jobs reports, perhaps with as many as a million jobs each, as the economy regained the millions of jobs lost during the pandemic. The data over the last two months have fallen well short of this expectation. There are a few potential reasons for the disappointment, including disincentives for labor supply and a natural speed limit on how many new employees can be onboarded each month. At this juncture, however, the reasons may not matter all that much. Chair Powell reflected quite a bit of optimism that the issues would work themselves out, and he said a number of times that he expects the labor market to fully recover over the next few quarters.

The practical implications of the labor market discussion appear to have been rather limited in today’s meeting. Certainly, the sluggish hiring rate over the last two months was not enough to head off a hawkish shift in forecasted policy. That said, perhaps the labor market disappointment did influence the FOMC in at least one way: the taper timeline was not moved up. Instead, Powell cautioned that any decision on the balance sheet was “still a ways off.” The lack of movement on the balance sheet may be somewhat puzzling, especially given the hawkish shifts in the FOMC’s forecast for rate hikes. The most likely reason for the disconnect is that if the labor market recovery is going to take longer, then the timeline to taper asset purchases will also take longer.

What to make of a meeting in which the FOMC appears to have placed more emphasis on the upside surprises in inflation rather than on the downside surprises in employment? We offer a few preliminary thoughts: First, the FOMC does appear to have made a shift today. Previously, the FOMC had suggested it would not react to inflation during the reopening, as any inflation was viewed to be mostly transitory. In contrast, after today’s meeting it seems the FOMC is at least somewhat sensitive to this year’s inflation prints. This is not to say that the FOMC cares more about inflation than about unemployment right now, but rather that realized inflation appears to be influencing the FOMC’s decisions more than previously understood.

Second, the shift in emphasis was only apparent in the three-year ahead forecasts, whereas the near-term action on the balance sheet was unchanged. While it would be going too far to ignore shifts in the FOMC’s forecast, it would also be inappropriate to give forecasts the same weight as actual policies. Accordingly, some consideration should be given to the fact that the FOMC did not accelerate its plans for tapering. Sticking with its balance sheet timeline signaled that the labor market disappointments matter, thereby underscoring the data-dependent nature of FOMC policy.

Third and finally, forecasts can shift meaningfully from quarter to quarter, especially in the current environment of heightened uncertainty. One frequently discussed risk is that inflation could prove more persistent than expected. While the FOMC likely discussed this risk, and that discussion perhaps influenced the forecasts, it seems almost certain that other risks were discussed as well. Another risk that may have been discussed is that the recent disappointments in hiring could be the start of a jobless recovery (or, more specifically, the risk that not as many jobs are recovered as were lost). Yet another risk may be that growth slows more than expected next year, following a truly unprecedented period of fiscal stimulus and reopening this year. Investors are best served by focusing on these risks, rather than on the FOMC’s forecasts, because ultimately the FOMC will be responsive to whatever happens. That is perhaps the most important takeaway from a day in which the forecasts shifted, but the FOMC’s actual policies did not.

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