Nicholas Glinsman | January 11th, 2022
Last year, the Fed raced for inflation. This year, it will race against inflation. The question now is how sharp the bend will be.
Not so long ago, the Fed was worried. Why couldn’t it produce inflation at a measly 2 per cent? Indeed in the summer of 2020, the world’s most important central bank was so worried that it unveiled a framework aimed at stirring price pressures and spurring job creation. The centrepiece was the Flexible Average Inflation Target, or FAIT. FAIT would give officials the wriggle room to run the economy hot, with inflation surging past its 2 per cent goal for an unspecified, but limited, period of time. Thus the US labour market would tighten. All while the Fed’s inflation-fighting credentials remained firmly intact.
The theory was that the past decade had shown that the US economy could tolerate far higher rates of employment without the risk of a debilitating spiral in wages and prices. So, as the pandemic shuttered firms, and jobs were lost, the Fed did the obvious thing. It embarked on a quest for inflation that consisted of rate cuts and unprecedented injections of liquidity into financial markets.
EUREKA! Now inflation is here. Throughout the first half of 2021, Fed officials promised it would be transitory. But November’s CPI came in at 6.2 per cent, and tomorrow we get December data, consensus forecast being 7.0 per cent.
This inflation, it seems, is sticky and far higher than the Fed might like. And so, it’s changing course. After indicating earlier in the pandemic that rates would remain on hold until the end of 2023, minutes of the Federal Open Market Committee’s December vote published last week signal it’s mulling hikes during the first half of this year.
All this means the US central bank is turning a corner. But what kind of manoeuvre will bury price pressures?
What everyone wants to see is a U-turn, a smooth and controlled change of bearing. In this scenario, the Fed will roll up to the lights, signal carefully and then seamlessly swing the policy-car around. Everyone will be happy. The FOMC will say it gave plenty of notice, beginning with the December minutes.
Investors can adjust their portfolios in an orderly way. The punchbowl will go. But nobody’s drinks will spill. Doubtful. The minutes have already sparked a sell-off in tech stocks. Actual rate rises will assuredly spook markets, hooked on a tiny federal funds rate and abundant liquidity as they are.
So, the Fed is in a tight spot. Three fates beckon. If it gets lucky, inflation is transitory and prices stabilise at 2 per cent. If it’s unlucky, inflation becomes entrenched at levels far above 2 per cent. And if it’s super unlucky, prices fall and this about-turn becomes an epic mistake. Quite the bind. What happens, however, is somewhat dependent on what the Fed will do. Small rate hikes to fight non-transitory inflation may mute that inflation, resulting in transitory inflation. At which point the rationale for FAIT would look reasonable once more. But this is too tight, and too uncertain, for a sweeping U-turn.
So, we may see a K-turn, a clunky three-point manoeuvre. There will be stops and there will be starts. Things won’t be smooth. Wheels will judder. And all the drinks will slosh. Some investors will get caught out, but we will avoid a major panic. Unfortunately, there’s a problem here too. A foggy windshield. The US’s expansionary fiscal policy will have unknown ramifications. And who knows what supply chains will do in 2022? We expect the snags to remain throughout the year. Others expect pressures to ease. Either way, the FOMC would have to act aggressively to offset the impact of stubborn bottlenecks. Plus, many investors are ignoring the fact that rates are at levels far lower than the last time inflation lingered around 5 per cent. The scale and pace of cuts priced in by markets may, therefore, be too meagre to fight truly obstinate price pressures. Here’s the point. If the Fed can’t see the future, and really can’t help but hike, it may well lose control of how far and fast these hikes must go.
Which brings us to a third option: a speedy J-turn. This kind of manoeuvre is rare. Ordinarily the preserve of the military, it spins the vehicle around sharply in reverse. The result is skull-rocking force. Yes, it’s quick. Yes, it’s effective. But for passengers, fun it ain’t. Everyone’s drinks will spill. And we, of course, are those passengers. Tackling inflation like this would pose deep questions about the viability of FAIT. Indeed, it would throw a question mark over the 2 per cent targets that have been the hallmark of central bank frameworks everywhere for decades. The concepts behind independent central banking look far from robust. Indeed, they look quite unwell. And a J-turn would be pretty scary too. Lurking ahead is the hobgoblin of financial crises. Central banks cannot reconcile tightening, to serve the needs of the economy, with ongoing accommodation, for wider financial stability. Super low rates risk financial bubbles and eventual turmoil. But super high rates risk popping those bubbles in calamitous ways. After years of quantitative easing, the incongruity between the monetary needs of the economy and the monetary needs of markets is inescapable.
All told, the spurt in US prices has revealed the flaw inherent in the open-ended FAIT. Now, the Fed will have a hard time driving out of Inflationsville without experiencing a crash. Backing out of years of accommodation will create conditions that require new accommodation. Normalisation will be anything but.
Meanwhile, in the interim, despite the rocky start for markets at start of 2022, financial conditions have not tightened markedly relative to history:
Two decade look at the Fed’s balance sheet
Inflation watch – Rents will prove problematic for inflation
Rents make up the single biggest portion of the consumer price index. By November, they were contributing more than any other single category to the overall number, except gasoline.
The growing contribution of rents, in green, to inflation was due to dynamics following the pandemic, which saw rents fall, and then rebound to their highest rate of increase since 2007:
While it has risen sharply, rental inflation remains within its long-term range. However, there is very good reason to expect rents to rise further. The housing sector has boomed since the worst of the pandemic shutdown early in 2020.As one good indicator of this, the Hoya Capital Housing 100 index, which covers a range of stocks that benefit most from a shortage of accommodation and an active housing market, has slightly outpaced even the mighty NYSE Fang+ index since the nadir of March 2020. There is intense activity in the sector:
Meanwhile, the mechanics of the way the official CPI data are collected gives us great leading indicators on where rental inflation is heading. The CPI captures the average being paid in rent, including people from the first through to the last months of their lease. Several different services monitor the rents on new leases. Zillow’s index suggests that rents rose more than 10% last year, and the official data can be expected to catch up. Meanwhile, census data shows vacancies dropping to historic lows, implying that the upward pressure should continue. The official rental inflation measure is much criticized. So, why does the CPI seems so far behind:
On the face of it, higher inflation of rents in 2022 is a very safe bet. Wilcox suggests that 6% or 7% is likely by year-end, which would be the highest level in three decades:
For those hoping to avoid sharp rises in target interest rates, this is bad news. There are serious arguments over whether tighter monetary policy can help control price increases driven by supply chain disruptions. But when it comes to the housing market, the relevance of a tougher Fed is obvious. Most transactions there rely on mortgage finance. Pushing up bond yields raises mortgage rates and should help bring house prices and rents under control, with a lag. Benchmark Fannie Mae mortgage rates have risen significantly in the last few weeks, but still remain far below even their level from the top of the last housing bubble in 2006. Further increases in shelter inflation would make it very hard for the Fed not to become much more hawkish.
Is US still backing the EastMed pipeline?
Europe’s energy independence is a key security concern for the US. This has been made abundantly clear by Nord Stream 2. There are some projects in the south of Europe that are to change the energy set-up for Europe in the medium term. They are still early stages, but could shift the balance in Europe in ten years’ time.
One of them is the EastMed project, a regional alliance between Cyprus, Greece, Israel with American support. With a length of 1900 km and a cost of some €6bn, this eastern Mediterranean pipeline is to transfer natural gas from the Levantine Basin to Greece, and from there to Italy and other European regions. For Greece, this project is geopolitical. It is intended to raise the profile of Greece as a European energy hub, according to KT Greece.
A non-paper from the US State Department has caused a diplomatic stir in Greece. It listed three reasons why the US should not lend diplomatic support to this project. The first is a preference for projects that can deliver both gas and renewables. The second is the lack of economic and commercial viability, and the third is that it would create tensions in the region.
Soon after the paper was sent to the Greek and Israeli governments, the State Department signalled there was no change in their offical position and support for the project. The US State Department spokesman reaffirmed Washington’s commitment to the EastMed alliance, adding that the US was shifting its focus to electricity interconnectors that can support both gas and renewable energy sources.
According to the State Department official, Washington supports projects such as the planned EuroAfrica interconnector from Egypt to Crete and the Greek mainland, as well as the proposed EuroAsia interconnector to link the Israeli, Cypriot and European electricity grids. These are projects that allow for both gas and the energy transition.
The EastMed pipeline’s construction was approved by Israel and Greece in 2020, and its completion is now scheduled for 2027.
US legislative process for outbound investment review, targeting China
Just before the holidays, Reps. Pascrell, DeLauro, Spartz and Fitzpatrick introduced legislation that would create an outbound investment review process. The bill is identical to Sen. Bob Casey’s “National Critical Capabilities Defense Act”.
Introduction of this bill in the House marginally increases momentum around establishment of an outbound investment screening process, which is not specific to China, but is largely directed at concerns that US investors are facilitating growth in Chinese industries and firms that either have a national or economic security nexus. To date, legislative interest in this issue has been confined to the Senate, which makes introduction of the bill in the House notably incremental in nature. House members such as Reps. Khanna and Gallagher, who are influential on tech/national security policy, have recently expressed an interest in this issue, which further contributes to momentum. Sen. Casey and others have over the last couple of years tried, but failed, to have this legislation added to the annual defense policy bill (NDAA).
There is now an effort to add the legislation to the U.S. Innovation and Competition Act (USICA), which provides subsidies to the semiconductor industry and includes contains other provisions that seek to bolster U.S. tech competitiveness vis à vis China. The USICA is a top priority for Senate Majority Leader Chuck Schumer, and is more likely than not to be enacted this year, given broad bipartisan commitment to it, though not likely before Q2, given other priorities on which Congress is focused in the meantime. The White House is separately interested in using its pre-existing authority (i.e., without Congressional action) to set up an outbound investment screening process.
The White House is likely to highlight the hawkish steps it is taking towards China before the Congressional midterm campaign season gets underway, which provides an incentive in the coming months to either initiate an outbound investment screening process on its own or push Congress in this direction.
Argentina and the IMF
It remains unlikely that there is sufficient support at the IMF (Executive Board/Members), including from the US, for a new IMF programme to be agreed with Argentina before its large March repayment becomes payable, and therefore, the country will likely fall into arrears with the IMF. To be clear, the impediment is not simply that the IMF Board and the US are resistant as a matter of politics. As noted repeatedly over the past several months, the gaps between the policies that Argentina has advocated and that its politics can bear and what IMF policies can support remain significant. Bridging those gaps will require concessions in accepting policies that are antithetical to either side. At least in the foreseeable future, do not expect the politics in either Argentina or Washington as trending in that direction, in spite of a collective will to try to avoid the arrears outcome. It has been reported in the Argentine press that it is the US Treasury that is leading the opposition to the new programme, especially given the outsized role of David Lipton,(formerly the FDMD at the IMF when the failed Macri programme was designed and implemented – this sounds credible. However, it is probably more accurate to assess that failure to come to agreement on a new programme will result from differences of opinion on programme design, how to fill financing gaps and internal Argentine politics and policies, and that the US is one of the countries most willing to point this out.
The possibility of resort to IMF Article V 7. (g) has been suggested by some, and this allows for postponement of repayments to the Fund in cases of exceptional hardship. But this is no longer a viable option, as there is not only resistance within the Fund to using this provision, but it is also no longer credible to argue that Argentina currently faces hardships that are especially “exceptional”.
The consequences of Argentina falling into arrears to the IMF are not likely to be immediately disruptive, though there will be headline risk both in and outside of Argentina. The IMF itself will likely need to recognize the need to dip into reserves, as the arrears will represent a loss on its balance sheet, which will not be material to its operations, but which will likely trigger the need for the US Treasury to explain the situation to Congress. Actually, even if the US were to agree to move ahead with a new programme, there would be Congressional notification requirements in any case.
Expect Republicans, already unhappy over the sloppy handling of the removal of FDMD Geoffrey Okamoto and his replacement by Gita Gopinath, to cast a sceptical eye on the IMF overall. There is not likely to be any immediate consequence, but with a sceptical Congress, the upcoming quota and governance reform process at the IMF, whereby China will be entitled to a large increase in voting share and quota, will be even more difficult to pass legislative political muster in the US, and thereby risks alienating China further from the IMF (and other IFIs) and exacerbating cleavages and undermining the international financial architecture that markets take for granted.