PIMCO: Inflation risks put the Fed in an uncomfortable place

Photo of Tiffany Wilding.

By Tiffany Wilding and Allison Boxer, Economists at PIMCO

As expected, the U.S. Federal Reserve announced the first reduction in its monthly pace of bond purchases at the November FOMC (Federal Open Market Committee) meeting, while also admitting that the outlook for inflation is more uncertain. Markets responded calmly to the news but looking ahead, Fed policymakers have the tougher task of managing markets’ rate expectations in the face of elevated inflation risks.

While we agree with the Fed that the currently high inflation is likely to dissipate, it now appears that it will take longer to dissipate than initially thought. Inflation that remains elevated for longer, even if it’s attributed to temporary factors, increases the risk that longer-term inflation expectations also adjust higher – something the Fed wants to avoid. Indeed, the next few months are likely to test policymakers’ patience, and we see meaningful risk of Fed officials’ expectations for rate hikes being pulled further forward when the Fed’s next economic projections are released in December.

Long-anticipated tapering is a non-event

The Fed announced its plan for beginning to wind down its purchases of U.S. Treasuries and mortgage-backed securities (MBS). In particular, it announced that it will reduce purchases by $15 billion per month in mid-November and mid-December. And while these monthly reductions are likely to continue through June 2022, the Fed also specifically stated that it is prepared to change the pace of monthly reductions if economic conditions warrant. After the Fed ends these secondary market purchases, we expect it will keep its balance sheet static by continuing to roll over its maturing proceeds at Treasury auctions or back into the MBS market, respectively.

Elsewhere, the FOMC made only minor changes to the statement to acknowledge that economic activity has started to rebound from the summer soft patch, and that inflation, while still “expected” to be transitory, has remained elevated as supply and demand imbalances related to the pandemic contributed to “sizable” price increases in some sectors. Meanwhile, during the press conference, Fed Chair Jerome Powell continued to assert that inflation is likely to be transitory, but he also emphasized the Fed’s willingness and ability to act to tame inflation if needed.

Markets recalculate the interest rate trajectory

Since the September FOMC meeting, we’ve seen a meaningful repricing of market expectations for central bank policy rates. In the U.S., markets have now priced in an elevated chance of a rate hike as early as the June 2022 FOMC meeting. While comments from Bank of England Governor Andrew Bailey were a likely catalyst of the move, we think the persistence of the shift in market pricing reflects upside risks to both U.S. and global inflation.

Yields on short-dated sovereign bonds in many countries have moved sharply higher in recent weeks, while those on longer-dated bonds have fallen modestly. This flattening of yield curves suggests investors expect central banks in several developed countries to start tightening sooner and at a swifter pace than previously thought. (For details, read PIMCO’s recent blog post, “Yield Curves Flatten as Investors Rethink Outlook for Monetary Policy.”)

Elevated inflation risks

Over the last year, strong consumer demand for goods coupled with various capacity constraints along the supply chain have contributed to higher inflation – these issues have been especially acute in the auto sector. This was expected to dissipate as the economy recovered from the pandemic; however, more recent developments will likely further contribute to additional inflationary pressures before dissolving next year.

Indeed, a confluence of factors, including aberrant weather patterns, elevated demand for manufactured goods, and policy changes, have resulted in low stocks of natural gas and coal. This has contributed to higher utilities prices in the U.S. as well as across global markets, and will raise headline inflation data. However, the diminished stocks have also contributed to outright power rationing in China, and shuttered production for many low-margin manufacturers in Europe and elsewhere, which can also temporarily affect core inflation as production of a wider range of goods is disrupted and businesses struggle to rebuild already depleted inventories.

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