Reality, not politics is behind the Fed's hawkish shift in its outlook for inflation
Soon after Jay Powell's re-appointment to Fed Chair, he started to sound increasingly worried that the current high inflation could persist. It might look like there's a connection. There's not.
Last week I heard someone in markets claim that Jay Powell had promised President Biden to get tough on inflation in exchange for his re-nomination. Then others in the room agreed. Uh? I want to set the record straight: No.
Source: On my walk a few Fridays ago. The Board is all decked out for the holidays.
Even so, it’s an important issue to address because the White House and the Federal Reserve are both rowing in the same direction toward a fast, equitable recovery. From the past—such as the Nixon Administration and the Arthur Burns Fed—we know that injecting politics into monetary policy is a serious risk to the economy.
I won’t feed you the standard line that the Fed is “independent of politics.” That’s something only academics believe. And it’s something the Fed will do almost anything to have you believe. Its credibility rests on doing the right thing; politics be damned.
Fed independence is mostly true, but every institution in Washington D.C. operates in a highly political environment. The Fed’s relationship with Congress, which is accountable to voters, is especially important to manage. Congress created the Fed and at any time could pass legislation to change its mandate, operations, or existence. See “Audit the Fed” or “End the Fed” movements. Yikes. Double Yikes.
As such, political reality does shape how the Board presents itself in public and what it draws attention to. One of my inadvertent Twitter ‘screwups’ as a staffer related to such optics.1 Oops. That said, more than any other government institution, politics do not affect Fed decisions about policy. Proof: the Fed enrages politicians and pundits across the political spectrum.
It’s not Red or Blue; it’s Fed.
As Sarah Binder and Mark Spindel argue convincingly in their excellent book, The Myth of Independence, the Fed always gets blamed. (See also a shorter piece by them here. They push back harder on the notion of Fed independence than I do.) Largely it’s blamed because the Fed won’t fight back and politicians often feel compelled to shift blame to someone else. (At times, it’s correct too. The Fed makes mistakes too.)
Powell’s hawkish turn is not about Biden.
All fine and good, but it is true on November 30, about a week after his re-appointment, Jay Powell’s remarks to Congress on inflation turned pessimistic:
“Most forecasters, including at the Fed, continue to expect that inflation will move down significantly over the next year as supply and demand imbalances abate. It is difficult to predict the persistence and effects of supply constraints, but it now appears that factors pushing inflation upward will linger well into next year. In addition, with the rapid improvement in the labor market, slack is diminishing, and wages are rising at a brisk pace.”
Contrast that with his ‘be patient’ tone at the press conference on November 3:
Supply constraints have been larger and longer lasting than anticipated. Nonetheless, it remains the case that the drivers of higher inflation have been predominantly connected to the dislocations caused by the pandemic—specifically, the effects on supply and demand from the shutdown, the uneven reopening, and the ongoing effects of the virus itself … Our tools cannot ease supply constraints.
You can see why some concluded that Powell had struck a deal with Biden. Inflation has taken over the media and is being weaponized to undermine Biden’s economic agenda. A Fed that’s tough on inflation, but not too tough, would be nice now for the President.
But that conclusion of a deal is wrong. The world had changed—data showing higher inflation and a stronger labor market—led the shift. That’s the Fed’s mandate from Congress: stable prices and maximum employment. As we get closer to that, the Fed should ease off its extraordinary support to the economy. It’s appropriate for the Fed to update its thinking (though I think they overdid it some) and for the Chair to say it.
The Chair is the last messenger of a change in Fed thinking
Powell’s testimony was the final step in the Fed’s messaging shift in preparation for this week’s FOMC meeting.
The Fed hates hates hates surprising markets, so it started laying the groundwork for the (almost inevitable) decision this week to end their asset purchases more quickly. At the November meeting, they set a course to finish by June 2022. On Wednesday, it will it move that up to March 2022. See my post last week for more.
Ok, so what does “laying the groundwork” mean? Top Fed officials start ‘dropping hints’ into their speeches, emphasizing the change in economic conditions that warrant the shift. It can be confusing with five Board members and twelve Reserve Bank Presidents who are constantly talking publicly. Here’s my cheat sheet.
Order of importance:
Fed Chair (Jay Powell)
Vice-Chair of the Board (Rich Clarida)
Federal Reserve Bank President of New York (John Williams)
(Editorial: three white men from elite backgrounds are the leaders of the Federal Open Market Committee. Do not talk about the “woke” Fed.)
A unique feature of the Powell Fed is there’s another key official to watch:
Board member, Lael Brainard.
Jay elevated Lael to “Troika,” which traditionally includes the Chair and the three roles above. So currently, it’s more of a “Quad” setting the agenda. I would put Brainard’s importance in messaging between Clarida and Williams (2.5). As I have said before, Lael and Jay are the dynamic duo. I am thrilled she be Vice-Chair soon.
Tapering is a case study in Fed communication.
When the Fed wants to shift, they start near the bottom of that leader list and work their way up to the Chair. That’s nearly always true (except in times of crisis like March 2020), and it’s true for this decision to end asset purchases more quickly.
In terms of economic outlook / monetary policy speeches: John on 11/30 and 11/17; Rich on 11/30, 11/19, 11/8. (Lael hasn’t had any since October.) Both (and many other Fed officials) have become more hawkish in their remarks and became more optimistic about reaching maximum employment sooner than expected.
This was all a lead-up to Jay messaging on November 30. My priors had shifted on taper well before Jay. He sealed it. And that’s how you avoid surprising markets. Nice work!
Wrapping Up
Institutionally, the Fed is a vast machine. Once you understand its logic—as counterintuitive as it may seem—its actions and words will make sense. It does not want to surprise you. It strives to be boring. It’s not always good at that. (I am worse.)
The Fed does not play politics, but politics play it. Jay and Lael did not make a deal with Biden to turn hawkish. That was already in the works.
Even now, the Fed is more dovish (as in committed to maximum employment) than I could have ever imagined. Look at inflation; look at the federal funds rate. Wow!!!!
Fed and fiscal policy are paying off. THE UNEMPLOYMENT RATE IS 4.2%. DOWN 2.5 PERCENTAGE POINTS THIS YEAR ALONE. (Can you tell I am excited?)
Now, knowing the White House economics team as I do (sigh), it looks to me like Biden will try to lever Jay’s re-appointment (a Republican) to get progressive in Vice-Chair of Supervision. It’s a bad idea, and I don’t think it will work in the current economic and political environment. We should know soon when Biden announces the rest of the appointments—still waiting. Given the delays, it would be a miracle to have the entire Board in place by June.
Remember to watch the presser at 2:30 pm ET on Wednesday. Bring your bingo card!
Below the paywall is my content for paid subscribers only—I discuss my rate forecast for next year and what to watch in the dot plot, which is the only thing I could see as market-moving on Wednesday. It shouldn’t, but traders gonna to trade.