As Omicron threat looms, inflation limits Fed’s room for maneuver


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The Omicron variant of the coronavirus comes at a difficult time for the Federal Reserve, as officials attempt to shift from containing the economic fallout of the pandemic to tackling persistent and worrying inflation.

The central bank has spent the past two years trying to prop up a still incomplete labor market recovery, keeping interest rates low and buying billions of dollars in government guaranteed bonds since March 2020. But now that inflation has skyrocketed, and as price gains increasingly threaten to remain too fast for comfort, its policymakers must balance their efforts to support the economy with the need to prevent price trends. price to get out of hand.

This new focus on inflation could limit the central bank’s ability to cushion any blow Omicron may bring to US growth and the job market. And in an unexpected twist, the new variant could even hasten the Fed’s withdrawal of economic support if it escalates the factors driving inflation to its fastest pace in 31 years.

“In each of the previous waves of the virus, the Fed has been able to respond by effectively focusing on downside risks to growth and trying to mitigate them,” said Aneta Markowska, chief financial economist at Jefferies. “They are not able to do it anymore, because of inflation.”

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The Fed’s attention to price hikes, even as a threat to growth looms, is a turning point.

Inflation, and especially inflation measures that eliminate food and volatile fuels, have been slow for years. The Fed has two goals, to achieve maximum jobs and contain price increases, and calm inflation meant it could focus on supporting growth and strengthening the labor market – as it has. during the early stages of the pandemic. But the sharp rise in prices this year has put the Fed’s two targets under tension as it sets policy.

The Omicron variant is in its infancy, and what it will mean for public health and the economy is unclear. But if it shuts down factories and other businesses and keeps workers at home, it could destabilize supply chains, causing more problems for the Fed.

There is a risk that Omicron “will continue this excess demand in areas that have no capacity and block recovery in areas where we actually have the capacity,” John C. Williams, chairman of the Federal Reserve Bank of New York said in an interview last week.

Janet L. Yellen, Treasury Secretary and former Fed Chairman, made similar remarks at an event Thursday.

“The pandemic could be with us for a while and hopefully not completely stifle economic activity but affect our behavior in a way that contributes to inflation,” she said of the new variant.

Their comments came just after Jerome H. Powell, the Fed chairman, signaled greater concern about inflation.

“In general, the higher prices we are seeing are related to the imbalances between supply and demand that can be attributed directly to the pandemic and the reopening of the economy, but it is also true that the price increases are occurring. have spread much more widely in recent months, ”Powell said in testimony to Congress last week. “I think the risk of higher inflation has increased.”

Fed officials initially expected the 2021 price hike to fade quickly as supply chains coped and factories worked with backlogs. Instead, inflation has risen at its fastest rate in more than three decades, and new data to be released on Friday should show that the ascent has continued as a wide range of commodities – like streaming services, rental housing and food – had more prices.

In light of this, Mr Powell and his colleagues have shifted into a fight against inflation mode, trying to ensure that they are prepared to react decisively if price pressures persist.

Mr Powell said last week officials would discuss accelerating their plans to gradually cut back their bond buying program – which has prompted many economists to expect them to announce a plan after their December meeting which would allow them to stop buying bonds by mid-March 2022. The Fed announced in early November that it would slow down purchases from $ 120 billion per month, making this possible acceleration a noticeable change.

Ending bond buying sooner would put officials in a position to raise their key interest rate, which is their most traditional and powerful tool.

A faster cut “could set the stage for a rate hike at the March 15-16 meeting, although this may be too early from a labor market perspective, although the pace of improvement remains rapid “Jan Hatzius, chief economist at Goldman Sachs, wrote in a research note Monday. Because his team thinks March would be premature, they expect an initial rate hike in June, although they say May is “very possible.”

Buying bonds helps energize markets and keep money flowing to borrowers, so slowing them down reduces additional support each month. A higher Fed interest rate would matter even more, lowering asset prices and making many types of borrowing more expensive, like auto loans, mortgages, and business credit. By raising borrowing costs, the Fed could cool demand, allowing supplies to catch up and lower prices over time.

Raising rates sooner would be a compromise. Unemployment has fallen rapidly, falling to 4.2% in November, but nearly four million people are still out of the labor market compared to just before the start of the pandemic. Some have most likely retired, but polls and anecdotes suggest many are left on the sidelines because they lack child care services or are afraid of contracting or transmitting the coronavirus.

If the Fed begins to withdraw support for the economy, slowing business expansion and hiring, the labor market may rebound more slowly and hesitantly when and if these factors subside.

But the balancing act is different from what it has been in previous economic cycles. The factors that are keeping employees on the sidelines right now are mostly unrelated to labor demand, the side of the equation the Fed can sway. Employers seem desperate to hire and vacancies have exploded. People are quitting their jobs at historically high rates, a trend such as TikTok termination videos have become a cultural phenomenon.

In fact, the at least temporarily tight labor market is one reason inflation may persist. As they compete for workers and employees demand higher wages to keep up with rising consumer costs, businesses are rapidly increasing wages. The employment cost index, which the Fed is watching closely as it is less affected by many pandemic-related issues that have clouded other wage metrics, rose sharply in its last reading – attracting the attention of decision-makers.

If companies keep raising wages, they can raise prices to cover their costs. This could keep inflation high, and anecdotal signs that such a trend is developing have already appeared in the Fed’s investigation of regional trade contacts, called the Beige Book.

“Several contacts mentioned that labor costs were already passed on to consumers with little resistance, while others said plans were underway to do so,” the Federal Reserve Bank reported. from Atlanta in the latest edition, released last week.

Still, some believe that inflation will subside by 2022 as the world adjusts to changing purchasing habits or as demand for vacations that has run into limited supply grows. ‘will fade. This could give the Fed the flexibility to be patient on rate hikes, even if it has positioned itself to be nimble.

Raising rates “before these people come back it’s a bit like throwing in the towel,” Ms. Markowska said. “I find it hard to believe the Fed throws in the towel so easily.”

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