How much tightening will be required?
The starting point is clearly relevant. While December’s headline inflation reading hit 7.0%, other metrics show more measured price gains. The last four months’ seasonally adjusted core readings annualize at around 6%. Predictive series like the ISM Prices Paid survey or Chinese PPI would suggest CPI begins to moderate in the next few months. These indicators have both reduced by about one-fifth, so let’s assume the Fed would need to reduce inflation by around 3-3.5ppts.
The FOMC minutes in March 2013 suggested that $500bn of QE (c. 3% of GDP at that time) led to an increase on inflation rates of merely 0.1%. A subsequent re-examination by the Fed during 2020 suggested a much larger effect of 0.3-0.4%. Finally, a cross-country meta-analysis of QE estimated a peak effect on inflation of c. 20bps for each 1ppt of GDP in QE and a run-rate effect of about 12bps.
If the Federal Reserve allowed a reduction in balance sheet to 20% of GDP — a target Federal Reserve governor Christopher Waller has in mind — it might correspond to a cumulative reduction on inflation rates of perhaps 2.5ppts. However the Fed begins 2022 still adding to its balance sheet! A plausible scenario would be a reduction of c. $800bn during 2022 (using Bostic’s guide from March onwards) which would impact inflation by well below 1% (perhaps 70bps).
"Expectations and the effects of Monetary Policy". Laurence Ball and Dean Croushore. NBER.
The Fed’s traditional tools (interest rate policy) would also be used. Research has estimated that the beta of inflation to changes in the Fed funds rate is 0.3-0.4x. So to achieve the remaining 0.5-1ppts reduction on inflation, the Fed would need to raise the Fed funds rate by between 1.5% to 2.8%.
However, monetary policy operates with a well-established lag. For QE/QT and rate hikes, that might be as long as seven quarters. So looking holistically at the situation, we may still be facing CPI of 4% during 2022. How the Fed chooses to react to such large deviations to their forecast will be a big swing factor for markets this year.
