By Nikolaj Schmidt, chief international economist at T. Rowe Price
During his Senate testimony yesterday, Federal Reserve Chair Jay Powell said it was time to retire the term ‘transitory’ when discussing inflation. Did Powell hereby indicate inflation pressures are permanent? Not quite. During the Q&A session of the hearing, Powell said that is great confusion about what the term transitory means.
To most people, transitory refers to a time interval, but in central bank speech, transitory means something that does not have a lasting impact on the inflation process – i.e., something not requiring a monetary policy response. According to Powell, it is appropriate to retire the term transitory to enhance communication between the Fed and the public. To an economist on the outside observing the process, the breakdown in communication associated with the term transitory has reached a point where the public is losing some faith in the Fed.
More relevant for monetary policy, Powell acknowledged it would be appropriate for the FOMC, in its upcoming meeting, to discuss whether the tapering process should be accelerated. Powell made these comments amid an environment of elevated concerns about the economic implications of the Omicron-variant outbreak. In my view, many market participants had expected Powell’s communication to tilt somewhat dovish – but this was not the case. Last, in response to questions, Powell acknowledged the Fed, and the economic forecasting community at large, had been too optimistic in the outlook for inflation. The problem in the forecasting process has been related to the difficulties in understanding a very unusual, pandemic related, distortion to the supply side of the economy.
Powell was more hawkish than the market had anticipated. Observers of the testimony could clearly conclude he is somewhat uncomfortable about the inflation process, and he left observers with an impression of an FOMC about to take a slightly more hawkish turn. However, the Powell was non-committal, and future deliberations by the FOMC will be predicated on additional information about the Omicron-covid outbreak. In case this information turns out to be of greater concern, the FOMC will respond appropriately. Admittedly, the bar for a slowing the current taper programme or the bar to deliver additional stimulus has been set extraordinarily high.
As for implications for financial markets, a further tightening of monetary policy amid the uncertain Omicron outbreak presents a challenge. It seems highly likely Omicron will have some negative repercussions for growth. Extrapolating from Powell’s comments, the Fed is not inclined, at the current juncture, to roll out additional monetary support to keep financial conditions accommodative. A more hawkish Fed amid a backdrop of slower growth should lead to a flattening of the US yield curve, with the front end moving higher and the back-end rallying. In turn, this bear flattening of the yield curve lends further support to the US dollar and will raise the volatility of the equity market. Over time, these factors are likely to lead to a tightening of financial conditions. In turn, this tightening will become a brake on global growth. Amid a somewhat more hawkish Fed, let us hope for benign news around the transmissibility and severity of Omicron