As many observers anticipated, and as the central bank itself telegraphed, the U.S. Federal Reserve signaled at its December 2021 meeting that a sooner start and faster pace of rate hikes is likely warranted over the coming quarters and years. The recent reacceleration in inflation measures and the associated rise in future inflation risks were likely the key drivers of the moves, which have the Fed winding down its asset purchases by March 2022, and likely hiking rates in June.
As a result of the unexpected persistence in inflationary pressures, and rising doubt about the extent of future labor supply improvements, we believe FOMC (Federal Open Market Committee) officials are now more focused on returning policy closer to neutral over the next several years, while remaining mindful that inflation could fully moderate on its own and that raising interest rates too early could arrest the economic recovery.
Higher inflation, greater risks
Since the previous FOMC meeting in early November, several important macro developments likely prompted Fed officials to shift their outlooks.
First, U.S. inflation (as measured by the Consumer Price Index or CPI) has reaccelerated, primarily as a result of additional supply chain disruptions due to the delta variant of COVID-19 as well as the destruction of vehicles due to Hurricane Ida. (For details, please read our blog coverage of the November CPI report.) PIMCO forecasts the reacceleration in U.S. inflation to continue for the next few months before ultimately moderating (on a month-over-month basis) in the first half of 2022. We agree with the Fed that the risk of persistently higher inflation is growing. We believe the longer headline inflation remains elevated, the greater the likelihood that consumers and businesses believe it is likely to remain elevated, resulting in behavioral shifts that could elevate inflation in a self-stoking spiral.
Second, although Fed Chair Jerome Powell noted that the labor market has likely not yet achieved maximum employment, it is “rapidly approaching” it. The U.S. unemployment rate (as reported by the Bureau of Labor Statistics or BLS) is now just 0.2 percentage points above the Fed’s most recent estimates of long-run equilibrium levels. Furthermore, markets may be tighter than implied by comparing the current level of employment relative to pre-pandemic levels. Indeed, with over 2.5 million people having retired since the start of the pandemic (according to the BLS) and increasing evidence of job-matching frictions due to the lingering effects of pandemic-related changes in individual behaviors, the specter of persistently elevated wage inflation appears much more prominent. Higher inflation expectations, and more aggressive labor bargaining for cost of living adjustments, could bleed into prices, and keep inflation elevated more persistently.
Third, the omicron variant emerged and spread rapidly around the world. Chair Powell’s comments earlier in December suggest that he sees greater risks that the new variant harms supply more than it dents demand, providing yet another potential tailwind to U.S. prices. We believe the timing and location of the omicron variant outbreaks will likely determine the ultimate impact on the U.S. economy. Many emerging market economies that are key suppliers to the U.S. remain well behind developed economies in vaccination rates, and several countries in Asia have been quick to implement additional lockdowns. To the extent omicron drives further disruption, it would come as retail inventories remain near record lows. Yet another delay to return to office and disruption to child care could also be a headwind to the labor market recovery.
December FOMC decisions
Given these developments, we believe the Fed is now much more focused on bringing policy back closer to neutral. And this shift in focus contributed to the Fed’s decision to more quickly wind down its asset purchase program, which is now expected to end in March (at the previous tapering pace, it would have run until June), and also to signal impending rate hikes. Indeed, based on the updated Summary of Economic Projections (SEP), a majority of FOMC officials envision hiking rates as early as June and hiking three times total in 2022; we also note that all Fed officials now expect at least one hike in 2022. Furthermore, the SEP indicated that five more hikes are likely to be warranted over 2023–2024, to bring monetary policy closer to levels consistent with neutral.
In our view, the Fed so far has masterfully navigated the adjustment in market expectations for the path of policy without materially tightening financial conditions. Indeed, PIMCO’s own U.S. financial conditions index (a proprietary index that summarizes information about the U.S. economy contained in a range of financial variables) is little changed over the past several months. However, even after December’s updated rate path projection, uncertainty and the potential for volatility remain as the Fed moves toward a somewhat tighter stance of monetary policy in 2022. In particular, Chair Powell noted after the meeting that the Fed discussed potential sequencing for running off the balance sheet, an added uncertainty about the path for monetary policy tightening.