Fed’s heavyweight report: short-term inflation risk upward, if inflation expectations continue to be high can change monetary policy

Federal Reserve Chairman Jerome Powell will appear before the U.S. House Financial Services Committee and the Senate Banking Committee for their semi-annual hearings on Wednesday, July 14 and Thursday, July 15, EST, respectively.

On the eve of this high-profile event, the Federal Reserve submitted its 75-page semi-annual monetary policy report to Congress to provide lawmakers with the latest news on developments in economic and financial conditions and monetary policy.

The report noted that in the first half of the year, supported by accommodative monetary and fiscal policies, progress on the new crown vaccination helped the U.S. economy reopen and rebound strongly, but the impact of the epidemic continued to put pressure on the economy and the employment rate remained well below pre-epidemic levels.

The report also acknowledges that survey- and market-based indicators suggest heightened upside risks to the near-term inflation outlook, but remains committed to the Fed’s consensus that higher inflation is only temporary and will fall back to its long-term target from next year, so there is no need to rush to adjust monetary policy at this stage.

The report promises to continue to provide strong support, inflation temporarily higher without the need to rush to tighten policy

The Associated Press believes that the Federal Reserve used this report to promise to continue to provide “strong support” for the economy until further progress in the recovery from last year’s severe recession.

Bloomberg also said that the report shows that the Fed’s asset purchases and commitment not to raise interest rates until inflation and employment targets are met “will help ensure that monetary policy continues to provide strong support for the economy until the recovery is complete.”

Reuters saw that while the rebound in businesses and households is on track, the Fed warned that material shortages and hiring difficulties are hindering the pace of the U.S. recovery and pushing up “temporary” inflation, and that the Fed also sees uncertainty about the speed and strength of the labor market recovery.

In other words, the semi-annual monetary policy report in line with the Fed’s June FOMC meeting minutes released this week, that is, acknowledging that at this stage of the U.S. economy and inflation rose more than expected, but inflation is temporary. Although officials believe that they will begin to scale back bond purchases earlier than expected, given the larger taper methodological differences, the Fed is remaining patient about adjusting policy.

There is also analysis that the current high inflation and job market recovery is mixed, Powell’s congressional hearings next week may be more tense atmosphere. His term will end in a little over six months, and the Biden administration has yet to send a definitive signal recommending his re-election. The Senate Banking Committee hearings directly related to his or his successor’s appointment hearings are more interesting.

Fed says inflation: Surge in demand meets production bottlenecks and hiring difficulties, exceptional circumstances to dissipate

With recent data showing strong U.S. inflation, the description of inflation and its expectations in the latest heavyweight central bank report is naturally of great interest.

First, the Federal Reserve believes that the pace of price increases beyond expectations is only temporary. The apparent rise in consumer price inflation since this spring is due to a surge in demand seeking to coincide with production bottlenecks and hiring difficulties. As these special circumstances dissipate, supply and demand should be closer to balance, and inflation is also widely expected to fall and get back closer to the Fed’s long-term inflation target of 2% a line.

The original article reads.

Consumer price inflation, as measured by the 12-month change in the PCE (personal consumption expenditures) price index, rose from 1.2% at the end of last year to 3.9% in May of this year, with the core inflation indicator excluding food and energy rising from 1.4% at the end of last year to 3.4% in May of this year.

This partly reflects the impact of the temporary “base effect” of falling prices at the beginning of the epidemic as households cut back on spending, and the more persistent but likely still temporary upward pressure on inflation from commodity prices facing supply chain bottlenecks, such as automobiles and appliances.

In addition, some service prices, such as airfares and accommodation, have risen sharply to more normal levels in recent months as demand has recovered. …… Higher import prices have also exerted further upward pressure on inflation, driven by price increases for commodities such as crude oil, commodity prices have also risen due to strong demand, and higher transport costs due to foreign bottlenecks have also exacerbated the impact of higher import prices in the first half of the year. The impact of higher import prices in the first half of the year.

The report also includes an important op-ed entitled “Recent Inflationary Developments. Its view is also that “the sharp rise in inflation this year reflects both a sharp rebound in prices after the fall at the start of last spring’s epidemic and a supply-demand imbalance caused by strong growth in aggregate demand amid supply chain bottlenecks, hiring difficulties and other capacity constraints,” all of which are temporary influences.

For example, other traded commodities such as crude oil, which indicates a partial reopening of the global economy, have rebounded in price since the second half of last year and continued to rise to multi-year highs this year, most directly affecting consumer food and energy prices, and rising raw material costs have led to inflation in other commodities. Supply chain bottlenecks in shortages of key components and packaging materials, and delivery delays are all involved in pushing up consumer prices, especially in the auto industry. Increased demand for services not only pushed up prices, but hiring difficulties also pushed up wage increases.


Recently, prices of some commodities, such as lumber, have fallen or leveled off from their spring highs, suggesting that inflationary pressures from commodities may ease or even reverse in the coming months.

The report acknowledges that the short-term inflation outlook is on the upside and that monetary policy could be changed if inflation expectations remain high

In terms of inflation expectations, the report also released an op-ed entitled “Assessing the Recent Rise in Inflation Expectations.

After an in-depth study of market- and survey-based inflation expectations indicators, the Fed noted that investors expect inflation to stabilize at around 2.25 percent after the recent spike, and said this is consistent with the Fed’s target, professionals also believe that inflation will return to its long-term target of 2 percent in the future. However, the report also acknowledged that the upside risks to the inflation outlook have shifted upward in the near term, meaning the risk of continued higher inflation has risen.

The report said that if higher inflation does not abate and begins to drive expectations for future prices “consistently above” levels consistent with the Fed’s 2% long-term inflation target, the Fed may “call for a change in the stance of monetary policy.

The original article reads.

So far this year, the sharp rise in inflation raises the question of whether the recent rate of price increases will be weakened by the dissipation of the special case of demand outstripping supply, without the need to change the path of monetary policy; or whether it will be followed by higher inflationary pressures and calls for a change in the stance of monetary policy, the latter triggered by long-term inflation expectations persistently above levels consistent with the FOMC’s long-term inflation target.

Both long-term TIPS and swap-based inflation compensation indicators have risen since the beginning of the year …… In particular, market-based inflation compensation indicators for the year ahead have risen much more than those for the next 2 to 10 years …… suggesting that investors now expect future One-year average CPI inflation will temporarily be slightly above 3% before falling back…and stabilizing at around 2.25%.

Indicators based on surveys of professional forecasters and primary dealers show a similar pattern, with forecasts for PCE inflation increasing sharply and well above 2% for all of 2021, but little change in forecasts for PCE inflation beyond 2022, which is only slightly above 2%. This pattern suggests that professionals expect the recent rise in inflation to be temporary and that the recent strong data have not changed their view of longer-term inflation.

Survey-based indicators of household inflation expectations have also risen in recent months, and similar to other surveys, the change in inflation expectations in the near to medium term is more pronounced. In the June University of Michigan Consumer Survey, households’ inflation expectations for the next 12 months were significantly higher than in February of this year, and also much higher than expectations for average inflation over the next 5 to 10 years, where the median expectation has only slightly rebounded.

In summary, the Federal Reserve sees increased upside risks to the near-term inflation outlook. The distribution of PCE inflation probabilities for 2022 in the survey of professionals suggests that the average view is that inflation will then have a lower probability of being below 2% and a higher probability of being above 3%.

However, the Fed also believes that the Composite Index of Common Inflation Expectations (CIE) has finally reversed its net downward trend since 2014, pushing up moderately to a level that may be more in line with the FOMC’s long-term target of 2% for PCE inflation, i.e., a “benign reading of inflation “.

The FOMC is prepared to adjust its policy stance as appropriate if there is a risk of impeding the achievement of the target, and is not opposed to negative interest rates

In terms of monetary policy, the report first said the FOMC Committee expects that maintaining the current target range for the federal funds rate is appropriate, and that the current near-zero interest rate policy will remain unchanged until labor market conditions reach a level consistent with its assessment of maximum employment and inflation has risen to 2% and is expected to moderately exceed 2% in some cases.

The report also expects the Fed to keep the current pace of bond purchases unchanged at $120 billion per month until substantial further progress is made in achieving maximum employment and price stability goals. In the next FOMC decision meeting, the committee will continue to assess the progress of the U.S. economy in achieving these goals since the adoption of forward guidance on asset purchases last December.

Notably, the report states that in assessing the appropriate stance for monetary policy, the FOMC will continue to monitor the impact of future information on the economic outlook and “the Committee is prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the achievement of the target”:.

For now, risks to the economic outlook due to the epidemic remain, and the FOMC is committed to using the full suite (full range) of tools to promote the twin goals of employment maximization and price stability.

The Committee’s assessment will continue to take into account a broad range of information, including interpretations of data on public health, labor market conditions, inflationary pressures and inflation expectations, and financial and international developments.

In terms of reference monetary policy rules, “simple rules cannot capture the complexity of monetary policy,” so the FOMC will maintain greater flexibility while remaining consistent with the key principles of good monetary policy.

In an op-ed entitled “The Fed’s Balance Sheet and Money Market Developments,” the report states that the Fed’s asset purchases since last March have led to a massive and rapid expansion of the Fed’s balance sheet, with total assets expanding to $8.1 trillion from $4.2 trillion before the epidemic last January, and net asset purchases also This has led to a corresponding increase in the size of its total liabilities.

Of these, reserve balances are the Fed’s largest liability, and asset purchases since the outbreak have increased reserves significantly to a record level of about $4 trillion, but reserve levels have remained largely stable from April to June of this year, largely due to growth in other liabilities, such as a surge in the use of overnight reverse repurchase instruments (ON RRP).

The column also analyzes why the use of overnight reverse repo instruments rose to a record high of nearly $1 trillion at the end of June this year.

In addition to the surge in bank reserves due to QE debt purchases, the sharp contraction in the U.S. Treasury’s general account (TGA) at the Fed from about $1.6 trillion in January to about $850 billion in June and the reduction in net issuance of short-term Treasuries were all drivers of the spike in overnight reverse repo demand since April and created a general environment of ample liquidity and downward pressure on money market rates.

To this end, the Fed technically raised its managed interest rate in June, raising the excess reserve rate (IOER) as the upper limit of the benchmark interest rate corridor and the overnight reverse repo rate as the lower limit of the corridor by 5 basis points each, causing the effective federal funds rate to rise to 10 basis points and the guaranteed overnight financing rate (SOFR) to rise to 5 basis points as of July 7.

However, in the column entitled “Forecasting Uncertainty” at the end of the report, the Fed said the lower target range for the federal funds rate is “a convention” and “it will not have any impact on future policy decisions regarding the use of negative rates to provide additional accommodation. It will not have any impact on future policy decisions regarding the use of negative rates to provide additional accommodation, if negative rates are appropriate. This seems to mean that the Fed is not completely unsupportive of a negative interest rate policy if necessary.

The Fed emphasizes that the recovery is far from complete and that labor, financial conditions and financial stability are problematic

In its overview of recent economic and financial developments, the report praised that

The labor market continued to improve rapidly in the first half of the year, with a surge in demand for labor outpacing the supply recovery, leading to a surge in job openings and accelerating wage increases in recent months. And against a backdrop of increased household savings, an accommodative financial environment, continued fiscal support and a reopening of the economy, household spending remains strong, spending on services is returning to normal, and the financial system and its core institutions remain resilient.

However, the recovery remains imperfect or not nearly complete, with op-eds dissecting both the uneven labor force recovery and the topic of financial stability development.

On the labor market side, the nonfarm unemployment rate remained high in June, the labor force participation rate has been generally low over the past year, and the epidemic may have accelerated structural changes already occurring in the labor market, such as the increased adoption of technology and a surge in retirements, leading to a future employment reality that may differ from the pre-epidemic period.

In terms of supply chain bottlenecks, the timeframe for addressing them is uncertain, as they reflect both global supply chains and the causes of tight conditions specific to some industries.

In terms of financial conditions, large firms and households with good credit scores continue to have adequate access to financing, while financing conditions for small businesses and households with lower credit scores remain tight.

In terms of financial stability, some financial vulnerabilities have increased since the last semi-annual monetary policy report, and valuations of risky assets such as equities and corporate debt have generally risen. Outstanding debt in the commercial sector remains high relative to income, available leverage metrics for hedge funds increased and rose to very high levels in early 2021, non-agency commercial mortgage-backed securities issuance weakened in the first quarter, and structural vulnerabilities remain in some money market funds, bank loans and bond mutual funds.

In summary, Powell should insist in next week’s congressional hearing that the recovery is not complete, that inflation is temporary, and that there is no urgency to tighten monetary policy in a consistent manner. The release of a number of important U.S. economic data such as CPI, PPI and retail sales next week also merits careful scrutiny.