The Fed continues to think inflation is transitory: Strategist

Betsey Stevenson, Professor of Public Policy and Economics, The Ford School at University of Michigan and Matthew Diczok, Merrill and Bank of America Private Bank CIO Fixed Income Strategist, join Yahoo Finance to discuss the market action following the FOMC meeting, Fed tapering, and inflation.

Video Transcript

- I want to bring in two guests now for their reaction to the Federal Reserve today. That is Betsey Stevenson, professor of public policy and economics, the Ford School, University of Michigan. And Matthew Diczok, Merrill and Bank of America Private Bank CIO fixed income strategist. Our thanks to you both.

So Betsey, I'm going to start with you. The Fed's signaling it may soon slow the asset purchases it's been using to cushion this economy. Did the Fed sort of walk the fine line and say just what the market needed for it to say in order to continue moving to the upside?

BETSEY STEVENSON: Well, I think what the Fed said today is what everybody expected. There was some speculation before the employment numbers had come out in September that maybe they'd start tapering a little bit earlier.

But the slowdown that really started in August is not a reversal, but just a slowdown from the kind of growth and recovery we were seeing in June and July. It put a little bit of a pause. And we've also seen a slowdown in the price increases that they'd be concerned about.

So all of that is said, we are on the right path. We didn't need to quite go as fast as people might have been thinking we needed to go in July. But this idea that we'd start tapering in November, I think that's what I expected before the news came out. I think that's what most people in the market expected. And that's what we heard.

And that's because we are starting to recover. And I think tapering is that first step before they start to think about raising rates. We got a long ways to go before the Fed's going to raise rates.

- Matthew, you're a fixed income strategist. What do you want to hear from Jay Powell? Is it about the pace of the taper? Or are you more focused on the dot plot and the interest rate projections?

MATTHEW DICZOK: So yeah, we'd like to hear mostly what he's saying on the pace of purchases, how fast they think they need to go. And my guess is we're not going to get a lot of details out of him.

But the reason the market's being so positive right now is really twofold. First off, as Betsey said, they put it right down the middle of the fairway, exactly what they'd been conditioning the market to expect. The market likes certainty. It likes to know what's coming. It got exactly what it was expecting. That's point one.

The second point, which is a little more detail-oriented, is they've been leaning on the transitory inflation theme for quite some time now. That's very important. Because that will really drive how much and how quickly and how high they go with rates. And core PCE, their forecast for next year only moved up 2/10 of a percent, from 2.1 to 2.3.

So they continue to think that inflation is transitory. We'll work its way through it. That gives them the ability to be patient both on taper and rate hikes. And that's one of the details in the summary of economic projections that the market's liking here.

- Betsey, you mentioned a moment ago you believe we're a long ways away before we start seeing interest rates move higher. In this meeting, half of the 18 officials expect to raise rates by the end of 2022. Do you believe in that timeline? And would that be an opportune time to start raising?

BETSEY STEVENSON: I think it's actually too soon to really say. I think that's a reasonable expectation. I don't know about you, but I think a year from now is a long time. And if I'm unemployed, or I'm trying to get a business off the ground, a year is a runway that sounds pretty good to me.

So you know, I think most people think that's what they release. Most of them feel that people need a one-year runway at least to really get things back and going. We're going to see whether that runway is enough over the next year. And I think that's when we'll see whether they can go forward with those projections and raise rates by the end of the year or not.

In this pandemic world, I'm not going to get in the business of trying to tell you what's going to be happening a year from now. Because I mean, who knows. We could have another variant. All sorts of things could happen.

But if I'm looking at the world as I see it right now, I think people are going to take the next 12 months to get themselves back into work, to get new businesses off the ground. And I think we'll start to see ourselves in a place that's mostly recovered by the end of next year or close enough that you feel pretty comfortable raising rates.

- Matthew, when we talk about raising rates, this whole topic of inflation-- I realize that they removed the cost of food and the cost of fuel. We have a note from a big investment bank today. Could see oil at $90 a barrel if it's cold winter. If you've walked into a grocery store lately in the real world, you are paying more for everything. You know, half gallon of milk at $6.99 in some places in New York.

The Fed can ignore that, or not? I mean, real world people are saying, this is not good.

MATTHEW DICZOK: That's a very good point. And that's the main question that people have to look at and have to think about. So we did see, obviously, a large spike in inflation. Right now it's running annualized basis-- it's 5% at this point year to date. That's 8% annualized.

The Fed got a break here on the last CPI report where it did moderate significantly. It's still going up, but the pace of acceleration has slowed. So that gives a Jay Powell and the FOMC-- gave them a good opportunity here to continue with their plans on taper and rate hikes later in 2022 or 2023. So for right now, again, they do believe it's transitory.

But to your point, you need to drive your car. You need to heat your house. You need to eat. These are real-world costs for people.

And you're seeing that. You had someone from the Conference Board on before. You're seeing that in some of the consumer confidence data. Consumer confidence is slipping, both University of Michigan and the Conference Board.

So people are not reacting to higher prices by buying more sooner. They're retrenching a little bit. So we do need to watch that. The Fed does need to watch that, which is one of the reasons we think that taper sooner rather than later would be better.

We don't know what the future holds, as Betsey just said. A year is a very long time from now. But if you're a central bank, and inflation is running at 8% annualized basis year to date, you want optionality. You might want to hike rates sooner. You don't know what the future holds.

The sooner you start the taper, the sooner you get through it, the sooner you can use rate hikes to deal with inflation if you need to. And if you're a central banker, you really want to have that optionality to use your rate policy as a tool.

So that higher inflation might be a reason to keep the taper going quickly, get through that, to then have rates as an option should they need it to bring overall prices down.

- Betsey, would you agree that a tapering sooner rather than later and having the pace of that taper be a little quicker would be the prudent thing to do with inflation-- albeit still transitory. The Fed continuing to use that word in today's statement. But with inflation still running hot, do you think that's the best course of action from the Fed?

BETSEY STEVENSON: The word's really important. And I do think we're going to see continued problems this fall. We're continuing to see supply chain issues. And if we continue to see things sitting at, you know, the ports, having trouble getting unloaded-- I tell you, I've had a dozen people tell me to go shopping for Christmas now, because it's going to get harder as we get closer to November.

I think these things are going to cause some issues for consumers. But I think the key is that they're not reacting by over buying and that's not continuing to push prices up.

So you know, I think the Fed is taking a wait-and-see attitude for a reason. They're waiting for new data to come in. I think that it makes perfect sense for them to start tapering in November. But I'd really like them to take all the data they get between now and then in making the decision about what's the right pace.

- Matthew, keep in mind that you may be interrupted answering this question by the chairman and his press conference. But we know they'll ask about pacing of all of this. So what's the question other than that you would ask the chair?

MATTHEW DICZOK: I think the question he's going to get is obviously the real estate market in China and any spillover effects. And we expect him to sort of tap dance away from that, not to be overly concerned about that. From our perspective, there's not a huge linkage between property developers, financial institutions in China and the US. So we don't feel that will be a global systemic issue. That's the one question he's going to get.

The question he should get and the question I would be asking-- which, Adam, you had a great question before on that-- is how do you know it's transitory? What will you be looking at to tell it's transitory? How long can consumers who you tell it's transitory-- how much can they deal with these higher prices?

And so that's what I would ask. Again, what are the signposts? He laid out five reasons in his Jackson Hole speech why he thought it was transitory. Are those just what he thinks? Or are those sort of mile markers we have to look at?

That is the key question. That is where the majority of his focus should be, is how do you really know it's transitory? Because that makes or breaks a lot of decisions here.

And again, the idea is not that they need to hike rates. The idea more is that they don't want to use two tools at the same time. They don't want to have quantitative easing at the same time they're hiking rates. So the way we put it very simply is they don't want to use two tools at once. They don't want to use the cordless driver while they're using the hammer. They've got to put the hammer away.

And so until they stop using one tool, they can't use the other tool. So the most important thing, what they should really focus on is, how do they know it's transitory? What will tell them it's not? How quick can they react if it's not transitory? And how will they contain that, so consumers, whose wages are not rising as quick, get through that.