Time Is Running Out

John Lim

INFLATION CONTINUES to sizzle. November’s Producer Price Index (PPI) rose 9.6% from a year earlier. Even after removing food and energy, PPI was up 7.7%. Both figures are the highest since 2010, when such data were first compiled.

This follows last week’s Consumer Price Index report, which showed inflation climbing 6.8% over the past 12 months. Since consumer prices lag producer prices, we can expect little relief from inflation in 2022.

All this must be foremost on the minds of Federal Reserve members as they meet this week. Price stability is one of its two mandates, so it’s widely expected that the Fed will accelerate the tapering of its bond purchases. This will position the Fed to raise interest rates sooner as it seeks to quell inflation.

Unfortunately, time is running out. A number of factors conspire to make the job of Federal Reserve Chair Jerome Powell a lot more difficult:

1. Inflation expectations are climbing. According to the Federal Reserve Bank of New York, inflation expectations one year out are 6%. This number has doubled since the beginning of the year. This is concerning because, once entrenched, inflation expectations can become a self-fulfilling prophecy.

2. Wages are on the rise. Wages are companies’ largest expense and hence a major determinant of prices. Wages also tend to be sticky, meaning workers are loath to accept cuts in wages. According to a recent survey by the Conference Board, companies plan to raise salaries by 3.9% in 2022. That’s the fastest pace since 2008.

3. The yield curve is flattening. The difference in yield between five-year and 30-year Treasurys was just 0.54 percentage point as of last week. The last time the spread was so small was during the depths of the COVID-19 pandemic in March 2020. A flattening yield curve has many people worried that a recession may be looming. Could we really have a recession when inflation is on a tear? Yes, it’s called stagflation.

4. The Fed must now walk a tightrope. Over the weekend, economist Mohamed El-Erian, a former deputy director of the International Monetary Fund, had some blunt words for Jerome Powell: “The characterization of inflation as transitory—it’s probably the worst inflation call in the history of the Federal Reserve.”

Alas, hindsight is 20-20. I give credit to Powell for pivoting on inflation. Instead of digging in his heels, he reversed course as the facts changed—although arguably he ought to have tightened monetary policy sooner. Now, Powell’s greatest challenge awaits him. Will he tighten the monetary spigots too fast and throw the economy into recession? Or will he drag his feet and allow inflation to spiral out of control? This is the question facing markets in 2022.

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