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Experts broadly believe the Federal Reserve will hold its policy steady when its Wednesday meeting ends and maintain their easy money stance, despite the improving outlook for the American economy.
This begs the question — what would cause the Fed to take a U-turn?
It won’t be talking heads on CNBC that get the Fed to reverse course.
It won’t be two months of ugly inflation readings.
Economists said the Fed is looking deeper — at inflation expectations.
“If inflation expectations move up — then they have an issue,” said William English, a professor at the Yale School of Management.
What are inflation expectations?
Suppose you and your partner have been talking about going to Bermuda as soon as the pandemic is truly over, but when you decide to pull the trigger, you find ticket prices have skyrocketed.
Many Americans would delay the vacation or decide a trip to the Outer Banks of North Carolina will have to do.
But if more Americans continue to buy plane tickets and other goods and services even as the prices keep rising, that will get the Fed’s attention.
Unmoored inflation expectations result in “people suddenly feeling that they’re in an environment where prices are rising faster and faster and faster. Then they will adjust their spending patterns. To avoid falling into the trap of inflation, they will purchase more today rather than tomorrow,” said Gregory Daco, chief U.S. economist at Oxford Economics.
This can become a vicious circle.
In other words, people’s higher expectations of inflation lead them to reinforce the very development that is happening. Not wanting to be harmed, businesses and producers will want to raise prices.
Pre-pandemic, the fear of an outbreak of higher inflation expectations was like talking about the dinosaur age. And many economists continue to dismiss the current fears as overblown.
After all, they note the Fed’s favorite measure of inflation – the personal consumption expenditure index – has mainly been below the Fed’s target of 2% inflation since 2012.
“I am not thinking that we have unwanted inflation around the corner,” said San Francisco Fed President Mary Daly last month, in a remark echoed by many of her colleagues.
But other economists think the Fed might be overconfident and think it is right to at least worry.
“Uncertainty about medium-term inflation is very high right now. Honestly, COVID is a completely different shock than we typically have. And so understanding what the implications are going to be for prices and wages two years out now is incredibly difficult to do,” said Patricia Mosser, a former Fed economist and now a professor at Columbia University.
It is important to understand that the Fed would not be removing its monetary accommodation because it thought consumer spending was profligate.
What would upset the Fed is the spending spree would be accompanied by higher yields on long-term Treasurys
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as bond investors demand higher compensation for lending the government money for long periods. This means higher government borrowing costs and concerns about the ballooning federal budget deficit. These worries might weigh on the dollar in foreign-exchange trading.
“The Fed’s upside risk is a big pop in inflation that dislodges inflation expectations and is associated with a depreciation of the dollar – that sort of disorderly event,” said Vincent Reinhart, chief economist at Mellon.
What is the best gauge of inflation expectations ?
There are a “blizzard” of market-based measures of inflation expectations and surveys of economists, like the Philadelphia Fed’s Survey of Professional forecasters, but they come with problems.
Market-based measures of inflation are closely tied to the price of oil. And survey-based expectations suffer from inertia.
Daco of Oxford Economics says he likes the monthly report on consumer sentiment published by the University of Michigan for its one year and five-year measures.
The Cleveland Fed has an in-house estimate of inflation expectations updated monthly on the banks’s website. At the moment, it shows 10-year expected inflation is 1.48%. In other words the public currently expects the inflation rate to be less than 2% on average over the next decade.
The road ahead for the Fed “is going to be bumpy,” said Carl Tannenbaum, chief economist at Northern Trust.
Because low inflation readings at the start of the pandemic will drop out of the calculations, the government’s 12-month inflation readings are going to be “eye-popping” over the next few months.
The April reading for headline consumer prices, released in mid-May, could reach 4.5%, Daco said.
On top of that, as the economy reopens, there will be higher prices for some services — like plane tickets.
The Fed thinks that inflation, over the longer-term, could run closer to its 2% target than it has in the past. And they are willing to tolerate some higher inflation to make up for the years below 2%.
“It is going to be such a tricky communication challenge. The Fed will have to recognize that the situation is uncertain and requires careful monitoring,” Tannenbaum said.
For now, Powell and his colleagues can sit still.
Read: Powell to channel his inner-Gary Cooper to stay on easy path
But going forward, conversations about a possible U-turn in policy are likely to be required. The days of Powell’s “not thinking about thinking about” pulling back from the easy policy stance would be over.
“I think it would almost be disingenuous for the Fed to suggest that a conversation about how long to continue along the same policy path would be irresponsible,” Tannenbaum said.
