Contribution Central banks moving forward fast, how might this harm the economy?

Feb and BOK showing hawkish stances, but unlikely to overkill the economy

By Stephen Lee

Stephen Lee is the chief economist at Meritz Securities, Seoul. Courtesy of Mertiz Securities

Market participants are still concerned about stagflation. Economic growth expectations were revised down ― albeit slowly, while the inflation rate (and outlook) continues to trend up. Of course there are some risk factors which can materialize such as: China's Zero-COVID policy possibly adding to further supply disruption, and the ongoing geopolitical tensions surrounding Russia and Ukraine fueling up risks for gas and oil prices. If we'd assume these factors are to be short-lived, it is more likely that U.S. inflation will come down off of its peak (in terms of 12-month change) in the coming months. Here are some key pieces of evidences to consider.

First, month-on-month increases in the underlying Consumer Price Index (CPI) or Personal Consumption Expenditures (PCE) inflation have slowed, implying “additional inflation” pressures have likely peaked. Annualized month-on-month changes for trimmed mean CPI and PCE ― typical measure of underlying inflation, have slowed to 4.9 percent and 4.0 percent in December, coming down from 8.9 percent and 4.6 percent in October.

Second, the range of inflationary pressures have started to narrow-down. Inflation pressures were widely spreading from COVID-sensitive items to insensitive items or other. Pressure in the latter has been alleviated somewhat since December.

Third, the auto chip shortage has likely passed its worst period. We are starting to observe auto production and sales rebounding across the globe. The US used vehicle index compiled by Manheim.com ― preceding used vehicle CPI by an average of 2 months ― has risen only 0.04 percent in January. The seasonally unadjusted figure was down 0.9 percent over the month. More new vehicles available means reduced risk of resurgence of used vehicle prices going forward.

Fourth, wages will rise further, but likely at a lesser extent in the future. A recent survey from the National Federation of Independent Business (NFIB) shows that the percentage of respondents planning wage hikes started to come down from 32 percent to 27 percent in January. The labor participation rate also rebounded in the month, implying more labor supply and less wage pressures from a labor shortage. If the Omicron variant impact is to also wane in near future, that would also prompt more labor supply.

How will the Fed step up?

Still, these are merely early signs of additional inflationary pressures coming down, and it will occur step by step. The inflation rate will come off of its peak, but far away from the Federal Reserve (Fed)'s target of 2 percent PCE deflator growth. CPI and PCE inflation is likely to peak out from mid-7 percent and mid-6 percent respectively. The gap between target and actual inflation has widened, it's now inevitable that monetary policy will have to play its traditional role ― containing inflation.

The Fed has moved fast forward since their “Pivot-to-inflation” in mid-November. The previous stance of “full-employment first” is no longer valid. Now they've pledged asset purchases will end in early March and the first rate hike will take place in March FOMC. On the other hand, they haven't showed much guidance implying how much of a rate hike is optimal and how that combines with the balance sheet runoff expected to start within the year. Chair Powell's comments from January FOMC mentioning monetary policy should consider all plausible outcomes, implying a possible walk-away from gradualism, fueled even more fears. Federal Funds Rate (FFR) futures now imply more than five hikes during the year, with balance sheet runoff starting in less than six months.

Is the Fed really throwing away the punchbowl? In other words, is this to significantly sacrifice economic growth? For now, I believe it is unlikely due to several reasons.

First, the Fed would let FFR run above the neutral level (2.50 percent) if long term inflation expectations of professional forecasters surge beyond historical range. Fortunately it stands at 2.08 percent as of 4Q21, well anchored at 2 percent. It is more likely for the Fed to frontload the number of rate hikes in the earlier part, rather than having monetary policy to eventually weigh heavily on the economy.

Second, combining balance sheet runoff from the earlier part of liftoff would mean policy normalization being less dependent on FFR and aiming treasury term spreads to remain stable. This means even this year's number of rate hike is unlikely to shoot above what market participants expect now.

Third, as evidenced by the most recent comments by FOMC members, the Fed is likely to remain data-dependent in terms of policy decision. This means that if inflation pressures start to wane (with the help of supply factors) and eventually stabilize, the Fed can adjust their pace of further policy firming in the later part of the rate hike cycle.

The Fed would need to clarify their future policy path to reduce unnecessary uncertainty. We hope the Fed to initiate this process starting in March. We will have the revised economic outlook, dot-plots, and likely detailed information on the balance sheet policy.

Implications for the Bank of Korea

What implication would this have on the Bank of Korea's (BOK) monetary policy? Some argue that the Fed moving forward fast would provide policy rate hike maneuvers for non-U.S. central banks allowing aggressive rate hikes.

Inflation is also a problem in Korea, and CPI growth is expected to run above 3 percent for the next few quarters. But keep in mind that the BOK moved ahead of the Fed in terms of a rate hike. Korea's neutral level for base rate stands at around 1.8 percent according to our estimation, so there is chances for an additional rate hike or two. But if CPI growth slows to 2 percent by 4Q22, and if more evidence of apartment price growth stabilizing to low single-digit by then, as what I expect, it would also be unlikely for the BOK to go above neutral and possibly overkill the economy.

The writer is the chief economist at Meritz Securities, Seoul.