Inflation putting Fed’s FAIT regime to the test

Supply-chain bottlenecks and elevated inflation are expected to persist through at least early 2022, with many anticipating the Federal Reserve’s (Fed) reaction function under its new Flexible Inflation Targeting (FAIT) regime ahead of the November meeting.

 According to Ellen Gaske, Principal and Lead Economist for the G10 economies on the Global Macroeconomic Research Team at PGIM Fixed Income, the function serves to underscore the Fed’s tolerance for a 2% inflation overshoot for a period of time.

Gaske highlighted the different set of circumstances in the current economic climate compared to the period leading up to the FAIT announcement in 2020, when market-based inflation expectations consistently ran below actual inflation.

“The current surge in prices puts the Fed in a potentially challenging situation when it comes to defending the credibility of the new policy tool while acting in a timely manner in the event inflation continues accelerating,” she said.

Half of the Federal Open Market Committee (FOMC) participants are currently projecting rate lift-off by the end of next year, despite others continuing to voice some caution.

“Monetary policy often action with a lag, and raising rates too soon could endanger demand just as supply recovers to pre-COVID levels, which could threaten the economic market recovery,” Gaske said.

“We continue to side with the more cautious camp considering that the effects of fiscal stimulus are already waning, and the global supply chain should continue to recover as COVID-related conditions improve.”

Gaske also said the team at PGIM is watching for the release of US GDP data for the third quarter later this week, after growth was forecasted to slow to an annualised pace of around 2 .8%.

“We expect the source of growth to show a rotation away from consumer spending to inventory restocking and business investment,” she said.

“We expect companies will heavily invest in supply chain improvement and could rethink the lean, just-in-time inventory approach that has increased efficiencies, but reduced companies’ ability to cushion supply chain disruptions.”