The Fed’s conundrum — $7 lattes, $5 gas, 0% interest rates

Putnam Fixed Income Team, 11/17/21


  • The Federal Reserve’s approach to interest rates is creating economic uncertainties.
  • Powell’s second term at the Fed could hang in the balance amid political opposition.
  • New U.S. fiscal stimulus will likely lift demand further and add to inflationary pressures.
Inflation is running hot in the United States. Economic growth remains strong. Federal Reserve Chair Jerome Powell has defended the ultra-low interest-rate policy the central bank has pursued since March 2020. Against this dynamic, we believe the Fed is likely behind the curve in containing inflation.

Intuition or bad policy?

A responsible central bank would act to contain inflation expectations to avoid eventual stagflation. Stagflation doesn’t happen overnight. By gradually raising rates earlier in the cycle, central banks can re-anchor inflation expectations and maintain credibility. But raising rates too late means policymakers may have to increase them much more sharply to get ahead of inflation.

The Fed is currently behind on tightening. This, however, is not an isolated case; the central bank has previously lagged in tightening or easing policies. That said, we believe Powell will eventually do the right thing. Our base case scenario is for the Fed to act on rates after a lag of a few months, but political opposition could interfere with the process. Powell’s four-year term as chair expires in February 2022, and there is no clear indication whether President Biden will reappoint him. There are also other vacancies at the Fed.

There is political preference to appoint mostly “doves.” Powell is currently one of the most dovish members at the Fed. There is the possibility that Biden will appoint Fed Governor Lael Brainard, who is even more dovish, as chair. In addition, the Fed continues to grapple with the fallout from trades made by two regional reserve bank officials — former Dallas Fed President Robert S. Kaplan and former Boston Fed President Eric S. Rosengren. Both men — who made up the hawkish wing at the Fed — have resigned. With their departures, we have less confidence in the Federal Open Market Committee’s ability to assess changing inflation dynamics. That said, external pressures and the well-trained staff at the bank should be able to guide the FOMC on the right path, albeit with a delay.

Congress plays a role

Central banks might be the most important institutions anchoring inflation and inflation expectations, but they do not act alone. Central banks can print money, but without strong demand money does not flow through the economy. Inflation is sustained by high demand. High households’ savings and fiscal stimulus can propagate inflation.

Since the start of the pandemic, we have seen high levels of monetary and fiscal stimulus. In some sectors, activity has recovered to above pre-pandemic levels. But U.S. policymakers have maintained their expansive policy. At this point in the economic cycle, we believe additional stimulus will buoy demand and create inflationary pressures unless it comes with front-loaded tax hikes.

Higher levels of U.S. monetary and fiscal stimulus during the pandemic

Pandemic policies

Sources: Bloomberg, Federal Reserve, Putnam Investments calculations, as of October 2021.

Past performance is not a guarantee of future results.

A post-pandemic world

This pandemic differs from the post-global financial crisis environment of 2008-2009. The years immediately following the financial crisis were characterized by deleveraging. Fiscal support was limited, and monetary policy stayed accommodative for longer. In addition, monetary and fiscal policies moved in opposite directions, avoiding excessive stimulus. That changed with the Covid-19 pandemic. Initial stimulus policies may not have been accurately calibrated given the high levels of uncertainty, mobility lockdowns, and hospitalizations caused by the virus. We believe some of these stimuli could have been removed once governments had a better sense of the outbreak.

During the post-financial-crisis period, limited fiscal support and abundant monetary stimulus — as households were deleveraging — widened the income gap. Low growth and worsening income inequalities helped pave the road to political populism. Government fiscal balances were deteriorating well before the Covid-19 pandemic. This is a global trend. If populism is promoting the role of fiscal policy in an economy, then we believe it is time for monetary policy to take a back seat. Central banks are not the only game in town anymore.

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