Fed expresses concern about inflation without rattling markets

December 15, 2021 5:00 PM
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PIIE/Jeremey Tripp

The Federal Open Market Committee (FOMC or Fed) announced on December 15 that it will taper off its bond purchases faster than it expected just one month ago, with purchases likely ending in mid-March 2022 instead of mid-June. This decision was widely expected, but in a surprising additional move the Fed signaled that it is likely to raise interest rates by 0.75 percentage point in 2022 versus the 0.50 percentage point that markets had expected and the 0.25 percentage point the Fed signaled last September.

Overall, the Fed's decision may have hit a sweet spot by appearing to be on top of concerns about inflation without actually promising a tight monetary stance that could threaten economic growth. Financial markets seem to agree; bond and foreign exchange markets barely budged on the news, while equity prices rose a bit after initially falling.

The FOMC is belatedly catching on to the inflationary implications of a strong recovery from the 2020 recession coupled with supply restrictions related to the pandemic. Its latest economic projections show personal consumption expenditure (PCE) inflation of 5.3 percent in 2021 and 2.6 percent in 2022 on a Q4/Q4 basis. These are up from 4.2 percent and 2.2 percent last September and 2.4 percent and 2.0 percent last March. Some observers were warning of a large runup in inflation as early as last February.

In the press conference after the meeting, Fed Chair Jerome Powell emphasized the strong economy as evidenced by falling unemployment, high job vacancies, a high rate of job quits, and rapid wage and price increases. He blamed most of this year's inflation on supply bottlenecks rather than an overheating economy, but he noted that the unemployment rate is now projected to return to its pre-pandemic low of 3.5 percent next year. The Fed has stated that returning to maximum sustainable employment is a precondition for the rate hikes it expects to deliver next year.

Despite the hawkish announcement, the FOMC continues to project a path of interest rates that is low by historical standards. The median projection for the federal funds rate at the end of 2024 is only 2.1 percent, equal to the projected rate of inflation at that time. That would imply a very low real, or inflation-adjusted, interest rate of 0 percent for a year in which the FOMC projects continued solid growth and very low unemployment. It is likely that interest rates will need to go at least a little higher than that if inflation is to be restrained near its 2 percent target. Alternatively, perhaps the Fed will raise its target to 3 percent. The case for raising the target is strong.

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Joseph E. Gagnon Senior Research Staff

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