The Fed’s New Normal

Early this month, a Federal Reserve (Fed) release prompted a sudden market selloff.  The morning of April 5 started with considerable investor enthusiasm about indicators from payroll manager ADP.  These suggested that employment and hence the economy looked strong.  Equity indices soared.  The S&P Index, for example, gained some 25 points in no time.  It held that gain until 2:00 that afternoon when the Fed released the minutes of its open market committee (FOMC) meeting of the previous month.  These indicated that some on the committee wanted to begin selling off the bond holdings acquired during the quantitative earnings of previous years.  Concerned that Fed-provided liquidity would dry up and further spooked by the news that some committee members saw equities as pricey, at least relative to historic norms, the market turned down immediately, quickly reversing all the morning’s gains and closing down for the day.

The brief panic seemed to dissipate almost as quickly.  Markets rose the following day.  But if investors and traders managed to put their initial shock at Fed attitudes behind then, they had better get used to the new policy tone.  Unmitigated Fed liquidity support, so typical of past years, have clearly become a thing of the past.  FOMC members now seem more eager than ever to “normalize” policy, that is raise short term rates into line with historic norms and, to the extent possible, unburden their balance sheet of the huge bond holding they had acquired over the last few years.  Though policy makers have also made clear that they want to avoid shocking markets by moving too fast, they still seem determined to pursue their new direction.  They have any number of reasons.  The recent pickup in inflation is surely one of them.

Admittedly, the FOMC minutes avoid making too much of the inflation acceleration.  Policy makers nonetheless are well aware of three critical facts: (1) An excess of liquidity in the economy tends to raise inflationary pressure.  At least it has historically.  (2) Once inflation gains traction, it develops a momentum of its own.  (3) Policy has poured so much liquidity into markets in previous years that even the most active policy now will take a long time to erase its implicit inflationary threat.  An earnest effort over coming quarters can, of course, forestall any rise in inflation.  In part, that seems to be the Fed’s intent with its normalization policy.  The inflationary signs had to have made policy makers wonder whether they are pursuing their new policy actively enough.

Various inflation measures compiled by the Labor Department certainly make compelling reading.  Produce prices, which measure the cost of goods and services sold among businesses, have risen at almost a 3.5 percent annual rate so far this year, well above the Fed’s informal 2 percent target.  Consumer prices have travelled along a more moderate path, rising at a 1.6 percent annual rate during this time.  More telling from a policy point of view, however, is the longer-term pattern.  Measures taken over a 12-month stretch reveal these, for they blunt the effect of volatile sectors that can have an outsized influence over a 1-, 2- or 3-month readings.  On such a basis, producer prices have accelerated from virtually no inflation recorded last summer to a rate of 2.3 percent over the 12 months ended this past March, the most recent period for which data are available.  This is a considerable jump in seven short months.  Consumer prices, usually more stable than producer prices, have also accelerated on a similar basis from a recorded inflation rate of less than 1.0 percent last summer to 2.4 percent over the 12-months ended this past February, also a smart acceleration in a brief time.

These inflationary signs may carry a false signal.  Things of this kind have occurred in the past.  The Fed’s insistence on a controlled progress presumably takes this possibility into account.  But it would be foolish for the Fed or investors to ignore the unfolding picture, especially since inflation, once started, becomes very stubborn and can cause considerable harm to markets and the economy.  Any further indicators along these lines will keep the Fed on its normalization course.  Even if recent patters abate, policy makers can point to other reasons to stick to their normalization course.


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