Chief Economist’s note: Can the Fed spark a “controlled cooling”?

9:01 AM May 14, 2021

This week’s inflation data in the US was concerning. The Fed maintains it’s all “transitory” but they must be concerned too. Unlike the other market participants, they have tools to cool things down – but there are side effects.

All the discussion about the nature of 4.2% April inflation (that will be closer to 5% in May) will ravage for weeks. There are arguments supporting the transitory thesis:

  • Base effects of mostly low oil prices
  • Technological progress (e-commerce supports price discovery and thus keeps a lid on prices)
  • Demographic developments hurt long-term demand
  • Labour market remains far from full employment

Then again, there are arguments supporting longer lasting price pressures:

  • Households have more money than they’d have without the pandemic due to transfers
  • Companies face pandemic regime costs and higher input costs (see chart)
  • Supply issues allow for price increases
  • Lower competition in services increases pricing power
  • Signs of wage pressure (+higher minimum wage) despite 6% unemployment rate

Each of those factors from both lists warrants a separate analysis. However today, I’d focus on the scenario where the Fed conducts a controlled landing. Look at commodity prices – they are back at the ATH and this is actually understatement as this index is heavy in oil, while industrial commodities are actually soaring much faster. This is due to real demand from the supply side but also due to speculation – investors know that historically these assets performed well during “reflation” periods and amid zero-rates policy are flocking towards things like Copper, Aluminum, Iron Ores, Lumber or even Soybean.

Spot commodity prices are soaring, stoking inflationary pressure. Source: Bloomberg

So communicating even a slow exit from current “full speed” monetary stance could undercut this speculative demand and from the economic perspective would be the right thing to do. But the Fed knows this comes at a cost of ugly market reaction and thus will make such step only if they become seriously concerned.

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