Morgan Stanley
  • Thoughts on the Market Podcast
  • Mar 16, 2021

Fed Tightening Could Come Sooner than Expected

With Chetan Ahya


Welcome to Thoughts on the Market. I'm Chetan Ahya, Chief Economist and Global Head of Economics for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about the risks of an accelerated inflation trend as we emerge from recovery. It's Tuesday, March 16th, at 11:00 am in New York.

You may have been reading more about inflation recently, with some questions about whether a return to inflation could be transitory or see a more sustained rise. I would argue that the driving forces of inflation are actually aligned and a regime shift could be underway.

Sustained inflationary pressures are ultimately linked to the strength in demand, and by our estimates, the US economy will now reach pre-covid output levels this quarter; with the speed of recovery surprising most market participants and policymakers. It's a pretty remarkable outcome considering the shock that the pandemic inflicted on the US economy.

From third quarter onwards, our forecasts now expect US GDP to actually overshoot the path it was projected to follow before the recession. To put this in perspective, the last time U.S. GDP rose above prerecession path was back in the 1990s. And back then it took 15 quarters compared to seven quarters this time around.

Our US chief economist Ellen Zentner is forecasting growth of 7.3% in 2021 and 4.7% in 2022, almost 2 percentage points above consensus this year, and 1 percentage point next year. This gap between our estimates and consensus is, as far as I can remember, the widest ever.

As reopening gathers pace, the labor market is poised for a sharp rebound. This implies that consumption growth in 2021 will be supported by wage income and fiscal stimulus support to households, requiring little reliance on excess household savings built up over the pandemic.

If we are right, the surge in demand will quickly stretch resources, inevitably leading to higher inflation. Following a near-term surge in the spring, we see inflation remaining elevated above 2% this year and next.

Such a forecast may not concern the Fed, which is now explicitly targeting an inflation overshoot. But what happens when inflation stays above 2% sustainably accompanied by low unemployment? I, for one, am concerned that by the second half of next year, inflation could take a sharper turn into what I would term as the acceleration phase. I see a risk that inflation will not just moderately overshoot 2%, but could threaten to breach 2.5% - the Fed's implicit tolerance threshold.

I'll share two reasons why this concerns me.

First, the speed of recovery in the labor markets. While there is considerable slack in the labor market today, the rebound underway may turn out to be even faster than expected. In just 10 months, even with restrictions not fully lifted, headline unemployment has dropped from a peak of 14.8% in April, to 6.2% currently. For context, in the previous cycle, unemployment took six years to move from 10% to 5%, and as reopening enters full swing, accompanied by a surge in demand, the labor market will clearly improve at a markedly quicker pace than recent history suggests.

My second concern is uncertainty around the natural rate of unemployment, which is a term for the rate of unemployment that would trigger inflationary pressures. Although restructuring comes with every recession, this time around, behavioral changes resulting from the pandemic have accelerated the process. Hence, it is conceivable that the natural rate of unemployment has risen, and perhaps by more than normal.

Against the backdrop of a rapid labor market recovery, inflationary pressures from high wage growth could also surprise to the upside. As things stand today, with the Fed still far away from its goals, policymakers can maintain their forward guidance that the monetary tightening is still some time off. However, rapid progress towards those goals could easily overtake this guidance. Should inflation threaten to overshoot 2.5%, most likely around middle of 2022, it may bring a disruptive shift in expectations for Fed tightening, and with it the specter of volatility in financial markets.

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With the rapid recovery of the U.S. economy, it is possible that inflation will overshoot the Fed’s tolerances by as early as mid-2022.

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