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The Fed: Highest U.S. inflation in nearly 40 years will force Federal Reserve’s hand

The highest U.S inflation rate in nearly 40 years seen in Friday’s November CPI data, will prompt the Federal Reserve to begin raising its benchmark short-term interest rate sooner and higher than previously appeared to be the plan, economists said Friday.

Fed officials have been caught off guard by the pace of the acceleration in inflation and are staring at the risk of persistent price gains, said Josh Shapiro, chief U.S. economist at MFR Inc, in an interview.

Read: Inflation swells to 39-year high in November

“Their eyes are wide open right now for sure,” Shapiro said.

The critical point, Shapiro said is that so far inflation has been a story about goods prices.

But it looks like inflation is getting set to jump the rails to the service sector where labor costs make up the bulk of prices. If labor costs accelerate given the recent spike in inflation, the Fed will be facing “a very uncomfortable situation,” he said.

For years and years, labor costs have been under an “iron grip” but the pandemic has turned this on its head, he said.

In face of these new risks, the Fed will begin a journey next week toward a more neutral policy stance.

The Fed has been running super easy monetary policy, buying billions of dollars in bonds each month under a quantitative easing policy. Next Wednesday, the Fed is expected to double the pace of “tapering” of its asset purchases so that the program ends in March, a few months sooner than had been planned.

Fed officials will issue a policy statement next Wednesday along with new economic projections at 2 p.m. on Wednesday. Fed Chairman Jerome Powell will follow with a press conference at 2:30 p.m.

The unspoken message is that the Fed will be prepared to start raising interest rates sooner too, Shapiro said.

“I think they’re going to start doing 25 basis points rate hikes per meeting in the second quarter,

“It makes no sense to have interest rates where they are right now – both on the price front and on growth – zero sense, and they’ve kept them for too long to begin with,” Shapiro said.

David Wilcox, a former top Fed staffer and now a fellow at the Peterson Institute for International Economics, said it was important to view Fed policy as a thermostat with many settings rather than a simple on-off switch.

So next week, the Fed will be turning the dial towards less accommodative policy stance.

They will do that by penciling in a sooner “liftoff” of interest rates and a faster trajectory over the next three years than in September.

“What they are doing is not bringing to a halt the support they are providing for the economy. They are just turning back the dial some,” Wilcox said in an interview. In addition to continued asset purchases until March, the very size of the Fed’s balance sheet as a result of the purchases gives the economy a boost, he argued.

In September, the Fed’s dot-plot forecast of interest rates penciled in only one rate hike next year. The projections showed a gradual hike in the fed funds rate to only 1.8% at the end of 2024.

That’s below the 2.5% fed funds rate that the Fed believes is “neutral,” neither slowing down the economy or spurring growth.

Wilcox said it was plausible that the updated dot-plot will show the Fed hitting neutral by the end of 2024.

Yields on U.S. government debt
TMUBMUSD10Y,
1.454%

were mostly lower Friday morning, despite the consumer inflation reading that came in at its hottest rate on an annual basis in almost 40 years.

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