Our special focus this week is: Unpicking the Fed’s updated inflation outlook

Inflation has been on the tip of investors’ and commentators’ tongues, this newsletter’s included, since the back end of last year. With concerns growing among inflation hawks, all eyes were on last week’s eagerly anticipated FOMC meeting for a change of direction by Jay Powell. It didn’t disappoint.

As expected, projections for the Fed’s 1st rate hike were brought forward from 2024 to 2023. The Fed’s outlook for PCE inflation (its preferred measure) this year has been raised a full percentage point from 2.4% to 3.4%. Such a sharp revision upwards is unusual, to say the least, and a clear acknowledgement by the Fed that inflation pressure is building.Growth forecasts for 2021 were also revised upwards to 7% from 6.5% as the economy bounces back strongly from its pandemic-induced stupor.

Powell’s relatively more ‘hawkish’ stance received a jittery reaction from markets. What is visible in the forecasts for 2022 and 2023 (2.1% and 2.2% respectively – only marginal revisions upwards from the March meeting) is that the Fed continues to expect inflation to flatten out in the coming years and fall back into longer-term trends. In other words, the Fed still believes this year’s inflation spike will be a relatively temporary phenomenon. Appearing before Congress this week, Powell calmed markets by re-emphasising his commitment to supporting the US recovery and not raising rates too quickly.

Indeed, there is still no talk of tapering yet. But as the dot plot above shows, seven members are already expecting interest rate hikes next year – not yet a majority of members of course, but indicative of a building expectation of rate hikes. Typically, tapering takes place a year before rate hikes. With rate hikes likely to occur in 2023, talks over tapering will surely ramp up towards the end of the year in preparation for 2022.

Either way, this newsletter will keep a close eye on inflation and the different components driving it. CPI inflation jumped 5% in May (up from 4.2% in April), in part due to low base effects from last year’s deflationary environment. Commodity prices and, more recently, travel activities have recorded particularly strong increases, with transportation-related prices up 3.2% month-on-month in May, a 20% increase year-on-year. Most forecasters expect these pressures to ease – commodities are already softening – and thus their impact on inflation to peter out at some point.

A far more important element for inflation watchers to monitor is wages. So far, wage growth remains under control, with weekly wage inflation at 4.5% year-on-year, despite record job vacancies and small businesses in particular complaining about shortages of skilled labour. The phasing-out of generous unemployment benefits (most likely in September) should see more workers re-entering the workforce, potentially easing upward pressure on wages.

For the moment, the Fed and the markets seem to agree that inflation is under control and this year’s spike will be transitory: we’re not headed back to the 1970s. But one suspects many watchers will be waiting to see how future FOMC meetings pan out, before their fears of a return to stubbornly high inflation (and flared trousers) are completely dispelled.