Has Powell Just Killed Inflation?

Key points

• Market-based inflation expectations fell swiftly following Powell’s hawkish speech – possibly even too much.
• We provide a summary of our 2022 economic outlook: we see 2022 as the year when the pandemic shock is finally absorbed, with consumer prices gently decelerating, although the inflation risk in the US is tangible.

We were surprised last week by Jay Powell’s decision to take a “hawkish” approach to his testimonies to Congress by confirming the possibility to accelerate tapering – presumably to give the Federal Reserve (Fed) more space to hike rapidly next year – despite the emergence of the omicron variant. The market reaction has been swift, with expected 10-year ahead inflation falling back to or even slightly below the Fed’s target. We suppose that the Fed is focusing on the fact that GDP is exceeding its potential level and that it could deal with a moderate exogenous shock without wiping out inflation risks, but if expected inflation were to fall even marginally lower, this would suggest the market is taking on board the possibility  this might be a policy mistake. The contrast with the Bank of England was stark, since one of the most hawkish members of the Monetary Policy Committee – who had voted for a hike last month – talked about postponing the telegraphed tightening (again). The European Central Bank (ECB) acknowledged the increased uncertainty, but still looks intent to terminate Pandemic Emergency Purchase Programme (PEPP) in March 2022, with possibly some “two-stage” decision on Asset Purchase Program (APP). The variety of responses, beyond the differences in cyclical conditions facing the central banks, also reflects the lack of hard conclusion so far on the severity of the omicron variant.

Despite this new layer of uncertainty, we have published our “2022 outlook”. Assuming omicron proves manageable, we think next year would be a year of absorption of the pandemic shock, after the compression of 2020 and the brutal decompression of the economy in 2021. We continue to think global pressure on supply should abate, which would allow a gradual deceleration in inflation without the need of sizeable policy tightening (the Fed would hike but market interest rates would remain negative in real terms). When it comes to risks around the baseline, we think there is a tendency now to read European developments with US lenses, although the situation across the Atlantic is very different. The possibility to see inflation turning persistent is tangible in the US, while we think it is a much lower risk in Europe where wages have not showed any sign of acceleration so far and labour participation has rebounded to its pre-pandemic level.

If US inflation were to turn persistent, we think the Fed would react and consumer prices would re-anchor quite swiftly. Even a central banker more focused on full employment than on inflation would see that not hiking more would trigger a toxic market-led tightening with a higher cost to economic growth. Admittedly, this could be addressed by engaging in “QE infinity” with yield control, but we don’t think Jay Powell would countenance this.

We provide a summary of our 2022 economic outlook: we see 2022 as the year when the pandemic shock is finally absorbed, with consumer prices gently decelerating, although the inflation risk in the US is tangible.