Tightening But Not Yet

In a Wall Street Journal op-ed Alan Blinder encourages the Federal Reserve Open Market Committee to be “gentle” in raising interest rates:

Before the January FOMC meeting, a loud minority of market chatter was screaming that the Fed was behind the curve and calling on the committee to spring a hawkish surprise on Jan. 26—such as either raising interest rates that day or calling an immediate end to quantitative easing. Mr. Powell and his colleagues, being far less excitable, demurred. But they did strike a more hawkish tone, making it clear that tighter money—or, more accurately, less-easy money—is coming.

It is. But Fed watchers should understand that after some modest tightening, the central bank will be looking at two-sided risk.

Yes, as the worry warts say, inflation today is far too high, and there is a risk that it will remain too high for too long. The hawks are also correct to point out that the Fed is behind the curve and needs to play catchup. Finally, they are correct to point out that Team Transitory’s inflation forecasts haven’t looked good so far. (Confession: I’m a member.) With inflation stubbornly high, we could be on the cusp of a serious rate-hiking cycle.

Maybe. But there are also risks on the other side.

Start with demand. First and foremost, Covid-19 is still with us. Fear of infection appears to have taken a big bite out of retail sales in December, and that may be continuing into 2022. Second, the massive fiscal support that helped to power spending in 2020 and 2021 has mostly disappeared. In fact, the fiscal throttle is shifting into reverse. Third, businesses won’t keep accumulating inventories at the stunningly high rates of the fourth quarter of 2021. All this adds up to slower demand growth in 2022 than in 2021.

Turning to the supply side, while Omicron is keeping a lot of workers either sick or quarantined because they’ve been exposed, it looks to be subsiding quickly. There are also hints in the data that supply chains are beginning to cope better with the surge in demand for things that come in boxes. There is even a hint in recent data that consumer spending patterns are shifting back toward services, which don’t come in boxes.

Finally, let me add the “risk” that Team Transitory turns out to be right, and inflation tumbles faster than the hawks expect. The Fed’s last published forecast (in December) predicted 2.6% inflation over the four quarters of 2022—as measured by its favorite index, the deflator for personal-consumption expenditures, or PCE. Should something like that come true, PCE inflation would be pretty close to the Fed’s 2% target by late this year.

Let’s take a little poll. Which of these is scenarios is most likely?

1. The best case scenario. By September inflation has fallen faster than expected, GDP growth is robust, and unemployment is low.
2. The “Goldilocks” scenario. Inflation and unemployment have declined slightly while rate of growth of GDP has continued to rise.
3. Inflation and unemployment have risen a little, GDP rate has continued to rise.
4. The worst case scenario. Inflation has continued to rise, GDP growth is sluggish or even negative, unemployment is rising, it’s an election year, and the political temptation to do things which will actually worsen the situation will be irresistible.

I think probably C but D is also quite likely.