Announcement

ADP Research Institute (ADPRI) and the Stanford Digital Economy Lab (the “Lab”) announced they will retool the ADP National Employment Report (NER) methodology to provide a more robust, high-frequency view of the labor market and trajectory of economic growth. In preparation for the changeover to the new report and methodology, ADPRI will pause issuing the current report and has targeted August 31, 2022, to reintroduce the ADP National Employment Report in collaboration with the Stanford Digital Economy Lab (the “Lab”). We look forward to providing an even more comprehensive labor market analysis and will be in touch with additional details closer to the re-launch, later this summer.  For more information on this announcement, please visit here.

MainStreet Macro: Why the Fed is Not a Bread Maker

March 14, 2022 | read time icon 4 min

Nela Richardson, Ph.D.
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One of my favorite things to do on weekends is make bread.

It’s like magic. Measure the ingredients, toss them into the bread maker, close the lid, and press start. Three hours later, there you have it – a perfect loaf of warm bread.

In life, alas, things aren’t as easy or predictable. That’s especially true when it comes to monetary policy.

All eyes will be on the Federal Reserve this week as the central bank looks for a recipe to rein in inflation. Data released last week showed that consumer prices jumped again in February, rising 7.9 percent from the same time last year. That’s the highest rate of U.S. inflation since 1982.

The economy is a lot different now than it was four decades ago, and the Fed has no magic bread maker. And unlike flour, salt, and yeast, its policy ingredients don’t always produce the desired loaf.

As Fed governors prepare to meet Tuesday to figure out a recipe for fighting inflation, they know that their own policies can behave very differently depending on market conditions.

Here are three things the Fed will be watching.

Financial markets

When inflation threatens, the Fed typically raises the federal funds rate, which is what banks charge each other for overnight loans.

The Fed lowers the overnight rate when it wants to stimulate the economy, like it did in the early days of the pandemic.

Most consumers and businesses are unaware of the federal funds rate, but it sets the temperature for a lot of other things Main Street knows well.

The rate can influence the strength of the dollar and the cost of imports and exports. A change to the Fed’s overnight rate can affect stock prices, which feed into 401(k)s and other retirement funds. Rate-setting typically moves the bond market, too, making loans more or less expensive for business owners, homebuyers and other consumers.

The Fed keeps a close eye on all of it. If the market over- or under-reacts, the central bank might adjust how often and quickly it raises rates.

The labor market

In January, there were 5 million more jobs than unemployed workers, according to a Bureau of Labor Statistics report last week. Layoffs are more infrequent, and wages are up.

Despite these positive trends, the labor market seems out of balance. Employers report widespread labor shortages, and the pool of available workers is still smaller than it was before the pandemic began.

Wages were up 5.1 percent in February, but that wasn’t enough to keep pace with inflation.

This is where it gets awkward: The Fed might not want wages to meet inflation, at least not at this level of inflation. A rapid wage increase could trigger a spiral in which companies boost pay to keep up with cost-of-living increases, which could increase prices, and so on.

Its own balance sheet 

Interest rates are the Fed’s main ingredient, but in the last two economic downturns, the central bank has widened its influence by buying government bonds.

Bond buying, known as quantitative easing, is a relatively new item in the Fed’s pantry. Over the last two years, the Fed has bought more than $4.6 trillion in bonds to help boost growth. (That’s a lot of dough.)

Last week, it stopped. Now it’s trying to figure out how quickly it can peel off the $9 trillion worth of bonds it currently holds.

Unlike adjusting interest rates, it’s much more difficult to predict or control the impact of bond buying on inflation, and things didn’t work out so well the last time the Fed tried to shrink its balance sheet. A key credit market dried up, and the Fed had to stop just as it was getting started.

The central bank has never had to unwind a portfolio of this size. Fed governors – and markets, and Main Street – are bracing for impact.

My Take

Economists had anticipated last week’s high inflation reading, but the narrative around it has darkened.

In the weeks before the release, experts thought February would be a high-water mark and that the Fed would begin the work of bringing inflation back to a more comfortable range, below 3 percent.

That’s a challenging job even in normal times, to be sure. But the crisis in the Ukraine and a surge in oil prices since then have made the Fed’s goal much more difficult.

And there’s something else. Generally, when economists talk about inflation, they focus on core prices, not the broader headline number. That’s because core inflation strips out food and energy prices, which tend to be volatile month to month.

Core inflation was 6.4 percent in February, more than a percentage point below the headline number of 7.9 percent.

In the current environment, the conventional wisdom of giving credence to core inflation belongs in the compost bin.

Headline inflation, with food and oil prices included, matters a lot. That’s what Main Street reacts to, and Main Street spending is the bread and butter of the U.S. economy.

The Fed has a lot of tools, but a bread maker isn’t one of them. The central bank can’t just throw the same ingredients into the mix and expect the same results every time. The recipe needs to be customized to economic conditions.

And, unlike my bread maker, which delivers warm comfort in three hours, the Fed’s kitchen can take up to nine months to turn out a recipe. Even if they get it right, don’t expect a noticeable improvement to inflation before year’s end.