With financial markets already selling-off on fears over the Omicron coronavirus variant, it might have seemed like an odd moment for the chair of the Federal Reserve to make his most hawkish comments on monetary policy since the start of the pandemic.
But on Tuesday, Jay Powell effectively jettisoned the Fed’s previous stance on soaring inflation and signalled his support for a faster reduction of the central bank’s massive bond-buying programme, giving policymakers leeway to raise interest rates more quickly than expected.
In doing so, Powell sent a clear message to markets: combating inflation, which hit a 30-year high last month, is now the top priority for a central bank that has spent almost two years focused squarely on boosting demand and employment.
“Inflation has front-run their plans,” said Kathy Bostjancic, chief US financial economist at Oxford Economics. “This is something they were not anticipating and now they need to pivot and calibrate policy in order to achieve their goals.”
During two days of congressional testimony this week, Powell fleetingly acknowledged the emergence of the Omicron variant, which he described as a potential risk to economic growth that was not yet “baked into” the Fed’s forecasts. But he spent most of his time promising to tackle what he described as “persistently higher inflation”.
Powell warned that price pressures that were previously concentrated in a few corners of the economy had broadened out. And he retired the use of the word “transitory”, which the Fed has clung to throughout the year as it insisted the jump in inflation was tied primarily to temporary supply-chain disruptions.
By far the clearest sign that Powell is determined not to let inflation become “entrenched” was his revelation that he would support a much quicker “taper” of the bank’s bond-buying programme, with the stimulus withdrawn entirely “perhaps a few months sooner” than planned.
Even with roughly 4.2m more people out of work versus the start of the pandemic, and despite the looming threat of Omicron, the need to stimulate the economy has “clearly diminished”, Powell told the Senate banking committee on Tuesday. He stuck to the same script during another hearing on Wednesday.
Krishna Guha, a former Fed staffer who now is vice-chair at Evercore ISI, said: “This is a very abrupt pivot from the Fed: the eight-month taper plan was only announced four weeks ago and the New York Fed only began implementing it two weeks ago.”
Guha added that the abrupt change of tone would “fuel the sense” that there is a “much higher” chance of the Fed making a “step change” in its interest rate plans.
The announcement that the Fed would begin tapering its $120bn-a-month asset purchase programme in early November followed months of deliberations about the underlying strength of the recovery. It also marked the beginning of the end of emergency measures implemented at the start of the pandemic to stave off economic catastrophe.
The Fed initially said it would scale back it purchases by $15bn each month, meaning the programme would end in June 2022, while stressing it would be flexible based on economic conditions.
But economists at Barclays this week said they now expect the Fed to accelerate its taper at its January meeting so the stimulus programme ends in April. That would pave the way for interest rate rises a month later, added Barclays, which expects a further two rate rises in 2022, followed by four more in 2023.
“What is going on here is that Powell is looking at the level of inflation and looking at how fast the economy is growing and is starting to get worried that the Fed has been too easy for too long,” said Tim Duy, an economist at SGH Macro Advisors and the University of Oregon. “They are shifting the narrative.”
Financial markets reacted violently to Powell’s comments this week because an earlier end to the asset purchase programme probably means interest rate increases far sooner than anticipated.
On Tuesday, US stocks fell sharply and the yield on the two-year Treasury note — which is most sensitive to monetary policy adjustments — soared towards 0.6 per cent, having hovered as low as 0.44 per cent earlier in the trading day. It currently sits at 0.55 per cent.
Some Fed-watchers are not convinced the Fed will abandon its long-held cautious approach so quickly, however, especially given the huge unpredictability surrounding the new variant.
Roberto Perli, who previously worked at the Fed and now leads the global policy team at Cornerstone Macro, zoned in on Powell’s usage of the word “consider” this week when discussing the Fed’s tapering plans, and the central bank chair’s emphasis that officials will be watching data closely.
“If the Fed [sped] up tapering now, it would risk either sending a message of panic or admitting that it made a mistake a month ago,” Perli said.
Eric Stein, chief investment officer for fixed income at Eaton Vance, agreed that a material tightening of financial conditions might embolden the Fed to revert to its patient approach. But it would take a sizeable deterioration given how “strong and buoyant” risk markets have been, he added.
But for others, this was the week that Powell performed a much-needed pivot, turning himself from a soft dove to a hawk and decided to take on inflation more aggressively.
“The economy can absolutely handle slightly higher interest rates,” said Constance Hunter, chief economist at KPMG. “This shift in stance is consistent with the economic data and is consistent with maintaining [the Fed’s] credibility so that inflation does not get out of control.”