“But you can think of this meeting that we had as the talking about talking about meeting.”
Federal Reserve Board Chair Jerome Powell, Press Conference following FOMC meeting, June 16. 2021.
“I see the debate and disagreement as the Fed at its best. In a situation this complex and this dynamic, if I weren’t seeing debate and disagreement, and there were unanimity, it would make me nervous.” Federal Reserve Bank of Dallas President Robert Kaplan, June 30, 2021.
In May, we argued that the FOMC needed to communicate its contingency plans for what they would do should the recent inflation pickup prove more stubborn than its members expect. Such transparency makes it more likely that financial markets will respond to incoming data rather than to policymakers’ actions. By clearly laying out their reaction function, central bankers can avoid disruptions like market taper tantrums.
In June, the FOMC began to remove the self-imposed communication shackles designed to encourage “lower for longer” interest rate expectations and address inflation risks more openly. Indeed, as the above citation from Chairman Powell indicates, at their June meeting, policymakers began to lay the groundwork for scaling back their large-scale asset purchases (LSAPs).
To be clear, we share the broadly held concerns about upside inflation risks (relative to policymakers’ benign projections). Furthermore, we are not claiming that the Fed’s price stability goal is more important than its mandate to promote maximum employment (it is not). Rather, our view is that the FOMC could save itself substantial grief if it were to clarify further the conditions that might cause it to revise its inflation expectations and the path of policy going forward.
Against that background, the FOMC’s recent shift simply acknowledges that during periods of heightened inflation uncertainty—like the current one—anything approaching an unconditional policy commitment to sustaining LSAPs and keeping interest rates close to zero is ill-advised. Such a persistent insensitivity to economic developments would raise doubts about policy credibility, fostering risks both of a cyclical setback (if policymakers are later compelled to act without warning) and of needless financial market volatility.
In this post, we start by highlighting how recent Fed communication (which reveals appropriate humility about inflation projections) has helped avoid a market tantrum so far. Along the way, we discuss the various means that FOMC participants have used to express their changing views about the timing of interest rate increases (“liftoff”), even as they make clear that tapering their asset purchases will come first.
We start with the primary vehicle the FOMC uses to communicate its policy expectations: the Summary of Economic Projections (SEP), complete with its newly enriched and timely release of participants’ uncertainty and risk assessments. Compared with the March edition, the June SEP brought forward FOMC participants’ projected timing for liftoff. In the following chart, the red dots reflect individual FOMC participants’ federal funds rate target projections for end-2022 (black) and end-2023 (red). Compared to March, the June median for the end-2023 projected target rose by 50 basis points to 0.625%. In addition, 7 of the 18 FOMC participants now expect federal funds rate target increases in 2022, compared to only 4 in March. Notably, no FOMC participant anticipates liftoff to start this year. (We do not include 2021 in the chart, as all dots in March and June are at 0.125.) Furthermore, no one anticipates a return by the end of 2023 to “longer-run” policy rate norms—all of which are unchanged from March at between 2% and 3%..
FOMC participants’ federal funds rate target projections for end-2022 and end-2023 (Percent)
Note: Each dot reflects an individual FOMC participant’s projection (rounded to the nearest 0.125%). Source: FOMC June 2021 Summary of Economic Projections.
Importantly, the 2022-23 changes in interest rate projections are accompanied by almost no revisions in economic forecasts for the next few years. For example, median projections for end-2023 unemployment and core PCE inflation were unchanged, while the headline PCE inflation rose ticked up to 2.2% from 2.1%. Similarly, members’ perceived risks around their growth and unemployment projections remain largely balanced, as they were in March.
However, 13 out of 18 FOMC participants now see upside risks to their inflation projections; a substantial increase from 5 in March (see Figure 4C in the SEP). Indeed, the median projection still appears to lag simple models of near-term inflation trends. For example, in May and June, the St. Louis Fed “price pressures” measure indicates an 84% probability that annual PCE inflation over the next 12 months will exceed 2.5%—the highest in 15 years (see next chart). And, while uncertainty about growth and unemployment projections appears to be slowly receding, the FOMC is unanimous in its view that uncertainty about their current inflation projections exceeds its average level over the past 20 years (see Figure 4D in the SEP).
Probability that annual PCE inflation will exceed 2.5% over the next 12 months, 1990-June 2021
Note: This is the “price pressures measure” from the Federal Reserve Bank of St. Louis. Source: FRED.
Of course, the SEP was far from the only policy communication following the FOMC’s June 16 meeting. Chair Powell held his customary post-meeting press conference, where he stressed the Committee’s consensus view that the recent inflation pickup would prove transitory. He also emphasized that, in order to achieve its target on average over time, he and his FOMC colleagues intend to allow inflation to rise moderately above 2% for some time. Nevertheless, Chair Powell reiterated the importance of acting to anchor inflation expectations: “If we saw signs that the path of inflation or longer-term inflation expectations were moving materially and persistently beyond levels consistent with our goal, we would be prepared to adjust the stance of monetary policy.”
Over the past two weeks, numerous FOMC participants discussed how evolving conditions will influence policy. What emerges from this public dialogue—consistent with the widening range of SEP interest rate projections—is the kind of increased dispersion of views that we should expect in an episode marked by big fundamental shocks, large structural change and extraordinary supply-demand misalignments. Moreover, not only is inflation currently well above target, but employment is far below what policymakers believe is the sustainable maximum level. Against this background of enormous uncertainty, the lack of consensus is welcome (see the opening quote from Fed President Kaplan). It also is unsurprising that (at least for now) inflation concerns—and the case for advancing the timing of liftoff—come mostly from Federal Reserve Bank presidents, rather than Board members.
Naturally, the lack of policy predictability affects financial markets by raising the potential for policy surprises well above past norms. Even in ordinary times, the realized path for the federal funds rate can deviate substantially from the median SEP projection. Based on developments since 2000, a 70% confidence interval for end-2022 is from 0 to 2-plus percent, and for end 2023 from 0 to nearly 3% (see Figure 5 in the SEP).
Putting all of this together, and in light of high asset valuations and low real interest rates, we understand the widespread concerns about a future taper tantrum. Fortunately, as recent financial market developments suggest, by continuing to further elaborate how balance sheet and interest rate policy will respond as economic conditions evolve, policymakers can help contain these risks. For example, the following chart shows changes in key financial conditions on the day of the FOMC meeting (compared to June 15) and over the period from June 15 to June 28 (or 29). Not only are the one-day changes relatively modest (compared to past tantrums), but there is limited persistence. Perhaps the most enduring effect is the flattening of the yield curve, suggesting that investors interpret recent communication as consistent with the FOMC being prepared to contain inflation risks amid prospects for sustained growth.
Changes in Financial Conditions from June 15 to June 16 or to June 28/29 (Basis points or, where specified, percent)
Note: The changes for the S&P500 and the Broad trade-weighted U.S. dollar are in percent. Sources: FRED and BIS (exchange rate).
Ultimately, a key challenge for the Fed policymakers is whether they can be as patient as they would like. Their median projection implies that, after climbing to 5.3% over the past 6 months, PCE inflation will recede to an annualized pace below 2% for the remainder of 2021. The good news is that the most reliable indicator of trend PCE inflation that we currently have—the trimmed mean measure from the Dallas Fed—is running at 2.1% over the past six months and only 1.9% over the past year, well below traditional “core inflation” measures. (Furthermore, the trimmed mean PCE is a nearly unbiased indicator, averaging only 0.1% above the headline measure of 2.0% since 1990.)
Nevertheless, considering all the exceptional uncertainties we currently face, it would be imprudent to count on a simple extrapolation of past trends. Instead, our hope is that the recent increase in FOMC chatter—often criticized as cacophony that creates noise—will in these unusual circumstances continue to serve the useful purpose of setting the stage for a policy shift when it is needed. Indeed, we would argue that the June SEP—through its impact on private-sector expectations—already produced such a shift.
The bottom line: when uncertainty is high, lively policy debate is the order of the day. To paraphrase President Kaplan, if there were no debate, we would be concerned.