What to Watch This Week: The focus is on the Fed’s monetary policy meeting, which concludes on Wednesday.  The Fed starts the new year needing to re-establish its credibility to keep inflation – now running at a 40-year high – under control. Since its tilt toward tighter monetary policy began last October, the Fed has been quite agile, doubling the pace of its bond taper, pulling its planned date for rate hikes forward, and increasing the number of expected rate increases.

The Fed’s long-standing tradition of providing forward guidance well ahead of any policy shift counterbalances its newfound agility. The challenge for Chair Powell this week is to signal a March rate hike in a way that gives the Fed legroom to move aggressively – maybe even to the tune of a 0.50% hike – without spooking financial markets and snuffing out the economic recovery. The Fed will have to tread carefully with the mood remaining fragile (consumer confidence, Tues.; U of Michigan consumer sentiment, Fri.) and activity down (Q4 GDP and durable goods orders, Thurs.) owing to the omicron wave.

However, the Fed would be wise not to tread too carefully. A few days after the FOMC meeting, the Fed’s favored price and wage indicators (ECI and PCE deflator, Fri.) will be released, with both expected to reflect rising inflation pressures. Despite rising mortgage rates (new house sales, Wednesday; pending home sales, Thursday) and a slowdown of housing price growth, home sales will likely remain strong (Case-Shiller, Tues.).

Big Picture: The Fed is walking a tightrope as it prepares the framework for a series of interest-rate hikes that may begin as early as March. They’re responding to requests to slow the sharpest consumer price inflation in 40 years, while also avoiding the appearance of punishing employees at a time when they have unprecedented bargaining power, which is largely viewed as long overdue.

One way for the Fed to accomplish this is stick with the inflation expectations hypothesis, which has dominated mainstream economics since the 1980s. The notion is that if a central bank can persuade companies and consumers that inflation will remain low and steady, it won’t need to do much else. This is because inflation is assumed to be driven in part by predictions about where prices will go, e.g., workers won’t seek higher wages to compensate for their decreased buying power if they don’t expect higher inflation. They also won’t rush out to buy products because they expect prices to rise, resulting in a self-perpetuating upward spiral. That was the Fed’s error in the 1970s: it lost control of the public’s inflationary psychology to the point that managing inflation ended up requiring frequent and large interest-rate hikes, plunging the economy into recession, and throwing millions out of work.

The coming round of rate hikes is aimed at preventing just that; they aren’t really intended to quell today’s high inflation but are intended to prevent today’s inflation from becoming tomorrow’s.

We’re skeptical that the Fed can quell inflation without also hurting the jobs market, as there’s no sort of direct and painless way of influencing inflation without affecting something else in the economy. In short, the Fed’s toolbox is full of blunt instruments that, when used, often have unintended consequences. Rather, it’s more likely that any Fed tightening this year will slow the fall in the unemployment rate but won’t have much impact on inflation until next year, due to lingering but substantial supply bottlenecks amid swirling virus infection fears. By that time, inflation will likely have mostly vanished on its own: consumer’s excess cash piles will have evaporated, pandemic fears will have receded, allowing supply networks to untangle. It’s a scenario that will likely result in the Fed hiking less than the 3-4 four times that the markets expect this year.

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Source: Bloomberg Professional