In August 2020, the Federal Reserve (Fed) laid out its objective of flexible average inflation targeting. At the time, the trailing one-year rate of inflation was 1.3% and the trailing five-year rate was 1.7%. After years of undershooting its inflation target, the Fed said it wanted to overshoot its target to bring the average rate of inflation up to target.

Well, inflation escalated quickly. As of January 2022, the trailing one-year rate of inflation was 7.5% and the trailing five-year rate was 3.0%. The Fed has overshot its target of 2.0% by quite a substantial margin.

It wasn’t until April 2021 that it looked like inflation was moving out of bounds. That’s when Federal Reserve Chair Powell tried to soothe nerves by saying inflation was only transitory. Transitory has lasted longer than many originally thought. The surge in spending on durable goods by consumers flush with stimulus checks and businesses still closed or operating at reduced capacity was a recipe for higher prices. Recurring waves of COVID-19 led to repeated waves of supply chain disruptions. Consumers also had to postpone their shift back to services spending, keeping demand for scarce goods artificially high.

Now the Fed is poised to start a new mission: put the inflation demons back in their box while not upsetting a hot labor market. The new mission of the Fed isn’t an easy one. It’s complicated by Russia’s attack on Ukraine which is keeping energy and food prices elevated. The conflict could dampen business and consumer sentiment, as the future looks uncertain. The drag on growth and increase in energy and food prices has the Fed under pressure — remove accommodation to show they’re serious about inflation or maintain accommodation in case growth begins to falter.

There are two factions within the Fed. One faction wants to act aggressively to restore credibility as an inflation fighter. That would mean hiking the federal funds rate target to 1.0% by July 2022 and probably starting to shrink the Fed’s balance sheet by midyear, too. Another faction wants a more measured approach to show they aren’t panicking and because it’s generally believed that predictable and measured moves are easier for the economy and markets to handle.

The path of inflation is likely to be heavily influenced by the path of supply chain pressures. If COVID is becoming more endemic than pandemic, and if business activity globally — especially in China — gets back to normal, then goods price inflation could easily subside. Service sector inflation could stay relatively high, but on balance inflationary pressure should abate. Whichever way the Fed starts its rate hiking journey, it is likely to be able to shift into a slower gear as supply chain pressures ease, whenever that may be.

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