Taper tensions: Jay Powell under pressure as US inflation surges

Jay Powell, chair of the Federal Reserve, has so far succeeded in steering the US central bank and financial markets towards his view that the surge of inflation gripping America will be fleeting.

But confidence in that judgment was called into question on Tuesday after a larger-than-expected increase in the June consumer price index raised new alarm bells about the extent of inflation in the world’s largest economy. 

The data, which showed the CPI jumping 0.9 per cent in June from the previous month — for a year-over-year increase of 5.4 per cent — will pile pressure on Powell to explain his position during congressional hearings this week.

It also increases the risk of a sharper split within the Fed on the next steps in setting monetary policy. 

Some officials who sit on the Federal Open Market Committee believe the US central bank should quickly start reducing some of its support for the economy by trimming its $120bn of monthly asset purchases in light of strong growth in US output and high inflation.

But Powell has suggested the Fed should move cautiously on the grounds that the labour market remains far from a full recovery and inflationary pressures will eventually abate. He has the backing of several top officials, including the president of the Fed’s New York branch, John Williams. 

“The continued high [inflation] prints will increase tensions on the FOMC,” said Peter Williams, an economist at Evercore ISI.

“Some more hawkish members will likely point to the pattern in inflation over the past few months as suggesting that tapering should begin as early as September,” Williams added, although he predicted “the bulk of the committee will favour the transitory explanation for now”.

The CPI figures released on Tuesday do not necessarily point to inflation running out of control: annual price increases are spiking due to a combination of factors, such as the a burst of economic activity spurred by the post-pandemic reopening, supply chain bottlenecks and energy costs.

Line chart of Year-over-year change (%) showing US consumer price index soars

The Fed’s “base case” is that these pressures will subside over time.

Nor do central bank officials believe that long-term disinflationary forces — such as globalisation and automation — are in retreat.

And some Fed officials still worry that the Delta variant of the coronavirus, which is spreading rapidly, could hurt demand in the US, which might also tame price increases.

But the extent of the June consumer price increases highlights how, even if transitory, this period of soaring inflation in the US economy may be longer and more pronounced than previously anticipated.

For instance, the sharp increase in used car prices — one of the main factors behind higher US inflation — had abated before the June figures showed it once again accelerating.

“If, after a series of eye-popping numbers, people step back and say ‘this is not a one-off, this is a trend’ . . . we could get into a situation where inflation expectations start to move up,” said Randall Kroszner, a professor at the University of Chicago business school and a former Fed governor.

“That is very dangerous and problematic for the Fed.”

Market measures of inflation expectations have indeed moved higher in recent days, but still do not suggest broad-based concerns about runaway consumer prices.

One popular short-term gauge, which serves as a proxy for expected inflation over two years, now hovers around 2.8 per cent. Its longer-term counterpart, the 10-year break-even rate, sits below 2.4 per cent.

The containment of investor expectations underscores the Fed’s command of the inflation narrative, said Kroszner.

“Suddenly people are experiencing inflation that they haven’t seen [in decades], but that has not spooked the market, and it doesn’t seem to have spooked individuals,” he said.

“That is a very difficult needle to thread, and Jay and his colleagues at the Fed have been able to do that.”

Although Powell has embraced the view that the inflation spike will be transitory, he has also stressed that the Fed is far from complacent about the perils of excessive price increases — and that it stands ready to act if fresh data cause alarm.

“Forecasters have a lot to be humble about. It’s a highly uncertain business. And we’re very much attuned to the risks and watching the data carefully,” Powell said after the last FOMC meeting in June. 

During his appearances before the House of Representatives financial services committee on Wednesday and the Senate banking committee on Thursday, the Fed chair is likely to face criticism from Republicans who say the central bank is overly wedded to its “easy money” policies.

Pat Toomey, the Republican senator from Pennsylvania, recently told the Financial Times that the central bank risked falling “behind the curve” on inflation risks.

Still, Powell is not expected to signal any shifts in policy or communication during his appearances in front of lawmakers this week.

“His rhetoric on [inflation] is ‘we feel like we’ve got this under control, we think that it’s OK, but if the data changes we can adapt accordingly’ — that’s essentially what he’ll say,” predicted Ian Katz of Capital Alpha Partners.

He added: “The question is not going to surprise him, he’ll be ready for it. Maybe his answer won’t satisfy some people but that’s the answer they’re going to get.”

Democrats, meanwhile, will be watching Powell for reassurance that the Fed does not intend to waver from the central bank’s new monetary framework. That framework adopts a more lenient approach to inflation and a more dogged pursuit of full employment than in the past, as well as a reluctance to tighten policy based on the mere expectation of higher prices.

But especially after Tuesday’s data, some are concerned that by sticking to that plot the US central bank is allowing the economy to run too hot. 

“There are certainly elements of inflation that are transitory . . . but for anybody who talks to companies, they quickly get the message that there are a lot of things that are more persistent,” said Mohamed El-Erian, chief economic adviser at Allianz and former co-investment chief at the bond group Pimco.

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