Collision Course: Monetary Tightening Meets an Easy Money Bubble

Whether investors are ready or not, global monetary tightening cycles are fast approaching. The Reserve Bank of New Zealand raised its short-term rate twice in the last two months. Norway’s central bank raised its target rate back in September. The Bank of Canada is warning investors that it is speeding up its timetable for monetary tightening. More than half of emerging market central banks are already raising interest rates.

Here in the U.S., pressure is building for the Federal Reserve to taper its asset purchases more quickly. Jerome Powell, fresh off a nomination for a second four-year term as chair, and Lael Brainard, who was elevated to be vice chair, will be tasked to navigate higher inflation amid a tightening labor market.

Two points are worth highlighting following the nomination announcement. The first is that, considering how narrow the race seemed to be between Powell and Brainard, it seems likely that they will work together closely in guiding the direction of monetary policy over the next couple of years, maybe even more so than recent chairs and vice chairs. The second is that this next term may be very different than the last.

For Powell, the economic backdrop is starting out very different than his first term. With inflation mostly moderate during his entire time on the Board of Governors (an average of just 1.5% through the end of last year), Powell has been able to frame monetary policy in terms of “supporting” the labor market and “achieving the goal” of 2% inflation. With prices rising 6.8% year-over-year in November, that’s changed.

On the inflation side of the mandate, broad set of indicators show that trends have mostly worsened these last few months. Inflation has likely been a surprise to the more dovish members of the Federal Open Market Committee (FOMC), who noted back at the November 3rd policy meeting that the worst readings might have already passed and that forces were already in motion to bring inflation back to 2 percent over the medium term, according to recently released meeting minutes.

Is there a good way to gauge the level of concern held by Powell and other FOMC members about inflation over the next few months? Based on a speech this summer from Powell, and two more from Brainard, a set of observable indicators is available that offer a sense of how concerned they may be about continuing inflation risks. These indicators mostly fall into three categories – various measures of consumer inflation, wage trends, and inflation expectations. The indicators include ones they specifically mentioned or that capture an area of their concern. The range in each dial below is determined by the boundaries of the data over the last 20 years. A fully-shaded dial means that the current value is at a 20-year high.

The black lines show where the data were back in August, about the time the speeches took place. Dials are shaded by color depending on where current values are relative to August. The 5-Yr Forward Breakeven Rate is roughly at the same level as it was in August, so it’s shaded yellow. All of the other metrics, which have drifted higher to various degrees, are shaded red. When taken together, these gauges suggest that inflation concerns have probably risen for Powell, and help explain his change of tone last week in front of the Senate Banking Committee, where he suggested that a faster tapering of asset purchases will be discussed at the December FOMC meeting.