“The Fed is outside of politics but not our civic life. It has an obligation to display more intellectual rigor and honest realism than it did this week.”
Former Treasury Secretary Lawrence Summers, The Washington Post, March 17, 2022.
The Federal Open Market Committee (FOMC) is reassuring us that, so long as we are patient, price stability will return without further pain. But its narrative seems less grounded in historical experience and more like something Harry Potter might have conjured at Hogwarts. By the end of 2024, the Committee expects trend inflation (measured by the price index of personal consumption expenditures excluding food and energy) to drop by more than 3 percentage points while economic growth remains above (and the unemployment rate below) its sustainable level. And, all this magic materializes with the real (inflation-adjusted) policy rate barely turning positive. Unsurprisingly, we share former Treasury Secretary Summers’ skepticism about the FOMC’s fantasy (see the citation above).
The principal means by which the Fed affects the inflation outlook is by influencing financial conditions. Yet, having telegraphed its policy shift for months, the FOMC’s most recent actions on March 16—initiating a series of rate hikes and suggesting that balance sheet tapering could begin soon—barely affected the ease with which firms and households obtain financing. To see this, consider the two-day change of key financial indicators from the end-of-day prior to the announcement. The 10-year Treasury yield rose by 5 basis points, the two-year yield by 9 basis points, the S&P 500 increased more than 3%, and the dollar index fell around 1%. And, while financial conditions are indeed a bit tighter than six months ago—when about one-half of FOMC participants anticipated no interest rate hikes in 2022—these conditions remain quite accommodative (see here).
Is the FOMC’s current policy path consistent with its longer-term price stability goals? In the remainder of this post, we address this question by exploring policymakers’ newly published projections. Our conclusion is that bringing the inflation trend back to 2% will require a tightening of financial conditions significantly beyond what the Fed currently envisions, even if the interval for restoring price stability extends past the Committee’s current 2024 forecast horizon.
Turning to the details, in his post-FOMC meeting press conference, Chair Powell highlighted several factors—independent of monetary policy—that he and his colleagues believe will push inflation down. However, none of these—easing of supply bottlenecks, a shift back to services consumption from goods consumption, and rising labor force participation—is new. And, as the Chair noted, none have worked so far to satisfy the FOMC’s hopeful inflation projections.
As evidence, we turn to the quarterly Summary of Economic Projections (SEP). The following chart compares FOMC participants’ projections for core PCE inflation in the final quarter of 2022 from the last three SEPs: September 2021, December 2021 and March 2022. The rightward shift is largest in the latest version (red bars): indeed, the median jumped by an astonishing 1.4 percentage points (from 2.7% to 4.1%) and the lowest individual inflation projection in March 2022 significantly exceeds the highest projection made just three months earlier, in December 2021. If you ask whether this inflation “surprise” is merely a result of recent commodity price shocks, recall that core measures are designed to exclude recent spikes in food and energy prices.
FOMC participants’ projections for 2022 core PCE inflation
Note: Inflation projections are for the price change from the fourth quarter of 2021 to the fourth quarter of 2022. Source: FOMC Summary of Economic Projections, various editions.
Importantly, we find it difficult to see how the disinflationary factors Chair Powell identifies will lower inflation meaningfully anytime soon. For example, while earlier supply bottlenecks eventually should fade, the combination of Russia’s invasion of Ukraine and the ensuing policy response already have delivered new adverse shocks that sharply raised the prices of food, energy and other commodities. And, this seems likely to get worse before it gets better. Group of Seven governments already are moving to revoke Russia’s most-favored-nation trading status. And, if China seeks to aid Russia, secondary sanctions against Chinese entities could lead to an unprecedented breakdown of the global trading regime. The result is surely going to be both declines in activity and further increases in prices.
Similarly, short of much-slower gains in aggregate demand, it is difficult to see how we can escape an “extremely tight labor market” (Chair Powell’s characterization). The long-hoped-for rebound in U.S. labor force participation already may be largely behind us. While the current participation rate of 62.3% remains a full percentage point below the pre-COVID level (63.4%), it far exceeds the pandemic trough of 60.2% in April 2020. Moreover, labor force participation is running above the Bureau of Labor Statistics’ projected long-run trend, which is expected to sink to 60.4% in 2030. So, the only obvious way to ease aggregate labor market pressures on a sustainable basis is to slow the demand for the goods and services that workers produce.
Other disinflationary factors seem equally unlikely to materialize. While the shift back to services spending (and away from outlays on goods) may help slow goods inflation, services prices are rising rapidly and may receive a new impulse from the spending shift. Even excluding energy services, consumer prices for services are rising at a rate of nearly 4½%, the fastest since 1991. This is especially troubling, as inflation in services like shelter and food away from home tends to be stickier and more persistent than goods inflation.
Moreover, with limited opportunities to raise productivity in the short run, strong private hourly wage gains (up by 5.9% at an annualized rate since the pre-COVID February 2020 level) are likely to fuel additional price increases economy-wide. And, as Domash and Summers show, the current combination of a low unemployment rate and high rates for vacancies and quits suggests that wage inflation could remain high for some time.
Yet, current financial conditions are unlikely to slow aggregate demand. First, consumers’ nominal spending capacity remains abundant. For example, the ratio of M2 to GDP is still a whopping 28% higher than it was in 2019. Similarly, by our rough estimate, the accumulation of excess personal savings in 2020 and 2021—fueled by massive fiscal and monetary expansion—amounts to about one eighth of disposable income or 9% of nominal GDP. Much of this enormous buffer probably remains available for households to spend as their pandemic (and other) anxieties abate.
Second, inflation is making the real cost of financing housing and business investment unusually cheap. For example, adjusted for realized inflation over the previous year, the 30-year fixed mortgage has never been more attractive (see here). The same applies to corporate bond issuance, whether for investment-grade or high-yield firms. Finally, as of February, the Shiller cyclically-adjusted price-to-earnings (CAPE) ratio remained about 80% above its norm since 1960, suggesting that equity finance remains extraordinarily cheap, too. (No wonder a theater chain is investing in a gold mine.)
Against this background, the constellation of median projections in the FOMC’s latest SEP—with inflation falling substantially, growth above trend, and the unemployment rate below its longer-run level—appears virtually incoherent. As the following chart highlights, there has been no previous episode in which inflation (the black line) declined sharply and sustainably without a meaningfully positive real (inflation-adjusted) policy rate (the red line). Yet, that is precisely what the SEP forecasts (in the gray shaded area) anticipate. Moreover, were it not for the large projected decline in inflation, the real policy rate would remain negative throughout the forecast horizon.
Core PCE inflation, the Federal Reserve policy rate, and the real policy rate, 1970-2024P
Notes: The projections for the fourth quarters of 2022, 2023, and 2024 use the March 2022 median SEP projections for core PCE inflation and the federal funds rate. The real policy rate subtracts the realized core PCE inflation rate (or its projection) from the federal funds rate (or its projection).
Sources: FRED and March 2022 Summary of Economic Projections.
A comparison of the SEP median policy rate projection against a simple Taylor rule (based on private inflation projections) further fuels doubts that the FOMC’s projected policy path will bring with it a return of price stability. In the following chart, note that the Committee’s rate projection remains far below what the Taylor rule implies throughout the projection period (shaded in gray). In the past, whenever the policy rate was substantially below the Taylor rule, as in the 1970s, inflation has tended to rise, not fall. (Given this well-known pattern, it was particularly disappointing that the Federal Reserve’s latest Monetary Policy Report omitted what we thought was a routine and useful discussion of monetary policy rules.)
Federal funds rate, Taylor Rule rate, and projected rule rates, quarterly, 1970-2024
Notes: The Taylor rule (red) shown is the 1999 version that places twice the weight on resource utilization deviations compared to the original Taylor 1993 rule (see, for example, Yellen). To construct the rule rate, we use the real interest rate from Laubach and Williams, the core PCE price index, a target inflation of 2 percent, and the unemployment rate gap computed using the noncyclical rate of unemployment from the Congressional Budget Office. SEP federal funds rate projections are the median from the FOMC’s March 2022 Summary of Economic Projections. The projection based on private forecasts uses forecasts for the unemployment rate and core PCE inflation kindly provided by Mickey Levy and Mahmoud Abu Ghzalah of Berenberg Capital Markets LLC.
The FOMC must be painfully aware of its inflation forecasting failures over the past year. Yet, for the first time, the March SEP reveals that every participant views inflation risks as biased to the upside compared to their own forecast (see Figure 4.C). That bias (which was strong in the past three SEPs as well) suggests the FOMC again will revise its inflation projections upward in the June SEP—even if there is no further news about inflation.
Against this background, the press and market discussion of Fed policy seems dramatically misfocused. The key question facing the FOMC—and financial markets—is not whether policymakers need to make a 25- or a 50-basis-point rate hike at an upcoming meeting. Nor it is about when they should start the much-heralded passive tapering of their asset holdings (which appear to be having limited impact on financial conditions anyway).
Instead, the key question is whether the Fed has a credible plan to restore price stability within its projection horizon (or over a longer but clearly defined period), without precipitating a recession. Such a plan would have a more powerful impact on financial market conditions than any specific rate adjustment at a particular FOMC meeting. Importantly, a credible plan would need to explain how the peak projected policy rate that is needed to restore price stability compares with the Fed’s successful disinflationary policies of the Volcker and Greenspan eras, and with its growth and employment projections.
How high will that peak rate need to be? In our view, rather than a number below 3% (as in the FOMC’s median projection of 2.8% for 2024), it is likely to be at least 5%. It might not need to be as high if the FOMC were to forecast a recession within the projection horizon, but no previous SEP has anticipated a recession. Indeed, as far as we know, the FOMC has never anticipated a recession (see the history here). Moreover, even if there were such a projection, a premature policy easing still could lead to the kind of lingering stagflation that former Treasury Secretary Summers anticipates.
Our hope is that over the next few months, and especially when the FOMC issues its next projections in June, the Committee’s inflation policy narrative will be more closely linked to the experience of previous high-inflation episodes, making it both realistic and compelling. The FOMC’s Hogwarts-style conjuring is not reassuring.