Splits within Fed Widen

The Federal Open Market Committee (FOMC) voted to begin the process of tapering its $120 billion per month in asset purchases, starting with $15 billion less during the month of November. In a sign of splits emerging within the Fed about the persistence of inflation, the Fed left the door open to accelerate the rate of tapering of asset purchases after its scheduled December meeting. The Fed would like to finish the tapering of asset purchases before pivoting to a liftoff in interest rates.

What would force officials to accelerate the process of tapering? Two better months of employment in October and November could prompt the Fed to accelerate the tapering of asset purchases at the start of next year.

The FOMC tweaked its statement on inflation, arguing that although they think the current elevated inflation will be temporary, it may not be. Powell underscored the high level of uncertainty regarding inflation. Powell did say that he expects inflation to slow in the first or second quarter of 2022, much later than the Fed previously indicated. He admitted that it is possible we could reach full employment in 2022, which would justify rate increases in the second half of 2022. That is true even if inflation moderates.

Powell is hopeful that the current surge in wages will not compress margins and become more destructive. Margin compression can lead to layoffs. He stressed the surge in productivity growth as an offset to recent wage gains, but the gains are not spread evenly. Large, tech-savvy behemoths, which are driving wage gains, are much better positioned to absorb the shock of higher wages. Small and midsize businesses are already experiencing margin compression.

Powell made clear that the term “transitory” means different things to different people. He worried that it is distracting from the Fed’s message, which is that the Fed will do what is necessary to stop the current inflation from becoming entrenched. That will be a tough call as inflation moderates but becomes more broad-based in the second half of 2022. Shelter and medical costs are expected to place a floor on how low inflation can go in 2022.

What does the Fed believe is causing inflation? A demand surge, supply chain disruptions or labor market frictions? All of the above. The political rhetoric is muddying the waters on this debate.

Bottom Line
The Federal Reserve has been growing more divided over the course of the summer and into the fall. Chairman Powell would prefer to wait out inflation longer than many of his colleagues. But, he said “We think we can be patient. If a response is called for, we will not hesitate.”

We expect the FOMC to accelerate the tapering of its asset purchases in early 2022. This will open the door to sooner and more aggressive rate hikes. We now expect three rate hikes next year.

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