Delta Variant Reshapes Debate

The Federal Open Market Committee (FOMC) - the policy setting arm of the Federal Reserve - is scheduled to meet this week. The Fed will continue to welcome the improvement in the economy we have seen since the Fed last met in mid-June. Members will have to acknowledge that inflation has come in even hotter than they had expected in the official statement following the June meeting.

That said, look for Chairman Jay Powell to remain confident in his assertion that the surge we are currently enduring in inflation will be transitory. He will find comfort in the recent drop in everything from lumber to energy and used vehicles prices, all of which have come off the pandemic-induced highs we saw in June and should contribute to a moderation in overall inflation in the months to come.

Sadly, Powell will have to acknowledge the downside risks that are beginning to emerge from the spread of the Delta variant. The hope was that vaccinations would pick up enough to limit infections and contagion. The vaccines do appear to be holding up as expected; the worst outbreaks are among the unvaccinated. That does not preclude breakthrough infections, but it does point to fewer hospitalizations and fatalities.

The problem is the honor system for masking, which is fueling the spread in less vaccinated areas and upping the ante for breakthrough infections. The course of contagion in high contact areas including restaurants, bars and theaters could dampen consumers’ willingness to congregate unless they can be assured that attendees are vaccinated. FOMC members have no doubt heard of the same cases I have about offices where the honor system for masking has failed and prompted a shift in strategy. This is yet another hurdle for employers who are eager to get workers to return to their offices.

Many within the Fed will be pushing to taper the $120 billion per month in asset purchases - $80 billion in Treasury bonds and $40 billion in mortgage-backed securities. Powell will acknowledge that the Fed is discussing the asset purchase program but has yet to agree upon timing or strategy for tapering. Fed officials will want to see more progress toward their goals, notably on employment. Employment gains are expected to remain strong in July. August is dependent on school reopening, which we expect to happen on time this year.

The question mark is how spread of the Delta variant affects the return to work and whether it dampens some of the demand for services. We still expect the Fed to begin tapering by year-end but do not expect more clarity on the time frame from this meeting. Powell is widely expected to address tapering in his address at the annual Jackson Hole, Wyoming meeting in August. No actual road map for tapering by the Fed is expected before the September policy meeting.

Powell will push back on rate hikes in 2022, given the uncertainty posed by the Delta variant. He has made clear, however, that inflation will be transitory. It will either cool on its own as it seems to be doing. Or, the Fed will take action before inflation becomes entrenched in the economy. Powell doesn’t like to put a time frame on a decision that is outcome-driven, but he made it clear that he is willing to wait months, not years, for inflation to cool before acting more aggressively. The FOMC is looking for a moderation in inflation by year-end. If we do not get that, it will be much more aggressive in raising rates than most on the Fed currently expect.

Powell’s tenure as Fed Chair is scheduled to come to an end in January. He will dodge any questions regarding his recent meeting with the president at the White House. This administration has been even slower to fill appointments than the last two. Powell has been instrumental in shifting the Fed’s mandate on employment to include lowering the unemployment rate for underrepresented groups as well as the overall unemployment rate. He has a lot of credibility on both sides of the aisle in Congress but there is a push to get a more diverse leader at the Fed; the bench to fill that position is deep. Governor Lael Brainard and former Fed Vice Chair Roger Ferguson have been talked about for the job.

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