What to Watch to Understand the Fed’s Next Move—Beyond “Transitory” and “Permanent”

Last week’s Consumer Price Index (CPI) release, which showed a 6.2 percent increase in consumer prices since October 2020, added fuel to the debate of whether inflation is “transitory,” as Federal Reserve officials have asserted, or “permanent,” as some leading economists have claimed. The Fed’s interest rate decisions over the next several quarters—on whether and how quickly to raise interest rates— will affect the lives of average citizens, investors, and businesses.

 The problem with the argument about whether inflation is” transitory” or “permanent” is that the inflation that we are experiencing—caused by supply chain difficulties, higher energy prices, and job openings that can only be filled by increasing wages—may not be neatly classified as either. Most observers who have not vociferously joined the “transitory-permanent” debate probably would agree that one of the forces driving inflation higher now—namely labor market dynamics—will gradually subside as the pandemic becomes less prominent in the thinking of millions of workers who point to health concerns as a reason to avoid returning to the labor market. Since it is impossible to know when the pandemic will recede sufficiently for it to become a non-factor in individual decision-making, it is impossible to have confidence in either its transitory or permanent nature. Additionally, if it takes six to nine months to clear supply-chain bottlenecks, as many observers believe, and inflation dissipates as the supply chain gradually unclogs, should that process be described as creating “transitory” or “permanent” inflation?

Fortunately, determining whether inflation is “transitory” or “permanent” is not essential to understanding the Federal Reserve’s likely monetary policy decisions. There are two generally overlooked but critical variables that the Fed seems to be assessing in making monetary policy. One of these variables is the labor force participation rate. The labor force participation rate indicates the percentage of all people of working age (sixteen and over) who are employed or actively looking for work. In the twelve months ending in October 2021, the United States’ labor force participation rate was generally in the range between 61.4 percent and 61.7 percent. The Fed seems to be watching this rate particularly closely. In his most recent press conference, Fed Chairman Jerome Powell, stated that the unemployment rate understates the shortfall in employment, and then he explicitly noted that “participation in the labor market remains subdued.”

This focus on the labor force participation likely reflects two influences. First, the Fed’s recently completed a review of monetary policy, which concluded that the “maximum level of employment is a board-based and inclusive goal…the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level.” In other words, the goal of maximum employment, which is one of the Fed’s mandates, is no longer driven by the unemployment rate, which only measures how many individuals actively looking for work have failed to find a job. The unemployment rate had been the standard measure of full employment for years, but the Fed now considers how many individuals who could work are not in the labor force. The second factor that has induced the Fed to give new prominence to the labor force participation rate is that, prior to the pandemic, the Fed had allowed the economy to expand more quickly than many believed possible without triggering inflation and allowing the labor force participation rate to stabilize at a level of roughly sixty-three percent since 2013, after falling from a level in the high sixties before 2008. The apparently slight difference between the current labor force participation rate in the range of 61.4 percent to 61.7 percent and the pre-pandemic norm of roughly 63 percent translates into roughly four million people not participating in the labor force that the Fed would like to induce back into the labor force to achieve its newly expansive view of full employment.

The second metric to be watched in order to anticipate the Fed’s likely monetary policy movements is inflation expectations. As the name suggests, inflation expectations are the future inflation rate that households, businesses, and financial market participants anticipate. In an era in which current inflation is higher than the Fed’s publicly expressed long-run target range—the Fed seeks to achieve inflation that averages two percent over time--the Fed is eager to keep long-term inflation expectations from becoming “un-anchored.” The phrase “un-anchored inflation expectations” is a bit ambiguous, however. As a general statement, inflation expectations are considered “un-anchored” when long-run inflation expectations become significantly higher than the Fed’s target. “Un-anchored” inflation expectations are particularly problematic because business and households could make price and wage demands based on such expectations, and kick-off an inflationary spiral. Regardless of whether the current inflation is “transitory” or “permanent”, if inflation expectations are well-anchored, the risks of high inflation becoming a feature of the economy are thought to be significantly lessened.

The Fed has been very clear that its analytical tools suggest that the all-important long-term inflation expectations are reasonably well anchored. The Federal Reserve Bank of New York uses its Survey of Consumer Expectations, a monthly, internet-based survey, to assess long-term inflation expectations. The most recent assessment, published on September 24, 2021, has concluded that long-term inflation expectations remain relatively unchanged. The authors report that, to date, it appears that the surge in actual inflation has had relatively little impact on long-term inflation expectations. In addition to the New York Fed’s analysis of the Survey of Consumer Expectations, the Federal Reserve Bank of Philadelphia’s most recent Survey of Professional Forecasters suggests that professional forecasters’ inflation expectations are also reasonably well-anchored. The ten-year average inflation rate for the Private Consumption Expenditures index, the Fed’s preferred inflation measure, rose to 2.3 percent, hardly out of the Fed’s comfort zone. It is also possible to calculate the inflation expectations of bond market participants. These market-based readings of inflation expectations point in contradictory directions however.  The running inflation rate implied by fixed markets starting five years from now, the so-called “5-year, 5-year Forward,” is roughly on the Fed’s target.  However, the longer-term inflation expectations can best be described as “relatively volatile. The bond market calculation for inflation ten years hence, for instance, has risen from approximately 2.0 percent at the start of 2021 to roughly 2.7 percent most recently. Therefore, with these three surveys and market-based measures, one must conclude that the state of inflation expectations is uncertain, which cannot give the Fed, market participants, or average households much comfort.

In summary, while the debate of whether inflation is “transitory” versus “permanent” rages, the answer is probably less relevant to the Fed’s monetary policy actions than two other measures of economic health, the labor force participation rate and long-term inflation expectations. If one is trying to assess the likely path of interest rates, it is probably wise to track those two measures.