Analysis: Powell’s Omicron Comments Suggest Upside Risk For Faster Fed Taper

(This Analysis was first published on Tuesday, November 30 at 11:08 AM as an email to premium subscribers)

By Sophia Rodrigues

(Sydney, November 30, 2021)—Federal Reserve Chair Jerome Powell’s comment on the uncertainty from Omicron for inflation and labor market suggests the risk for faster taper of Quantitative easing and earlier interest rate hike is more, not less.

“Greater concerns about the virus could reduce people's willingness to work in person, which would slow progress in the labor market and intensify supply-chain disruptions,” Powell said in his prepared remarks to be delivered on Tuesday before the Senate Banking Committee.

While Powell said the new variant of the Covid-19 virus poses increased uncertainty for inflation, his comments indicate where exactly the risks lie, and it likely is for higher inflation.

Slow progress in the labor market is likely to be due to people continuing to stay out of the labor force because of caregiving needs and fears of the virus. This would be an additional pressure on the supply side that is already dealing with supply-chain disruptions and which Powell said would intensify because of the new variant.

Earlier in the speech, Powell said diminishing slack in the labor market is leading to brisk pace of increase in wages. Lower labor participation is not an improvement in the labor market but its effect on wages would be similar to labor market that is tightening due to growth in employment.

Powell said the Fed is committed to its price-stability goal and understands significant burden high inflation imposes on households, especially those less able to meet the higher costs of essential items.

“We will use our tools both to support the economy and a strong labor market and to prevent higher inflation from becoming entrenched,” he said.

While supporting a strong labor market is important and ultimate goal, preventing higher inflation from becoming entrenched would take priority in the near term. That is why it is possible the risk from Omicron is for more hawkish Fed policy, rather than less.

It is interesting that until the September FOMC meeting, Fed officials discussed there was still downside risk to inflation from a decline in inflation expectations if the public misconstrued the Fed’s reaction function as less accommodative than it actually was or because forces that held down inflation or inflation expectations had not gone away.

In November, all discussion on inflation expectations were mostly about upside risk, and some about expectations remaining well anchored.

From the November minutes: “In their comments on inflation expectations, a number of participants discussed the risk that, in light of recent elevated levels of inflation, the public's longer-term expectations of inflation might increase to a level above that consistent with the Committee's longer-run inflation objective; such a development could make it harder for the Committee to achieve 2 percent inflation over the longer run.”