Fed Monetary Policy in Crisis

The Federal Open Market Committee (FOMC) is facing a crisis of its own making. The crisis has four elements. Policymakers failed to forecast the rise in inflation. They failed to appreciate how persistent inflation can be. They are failing to articulate a credible low inflation policy. And, so far, there is little sign that monetary policymakers recognize the need to react decisively.

Our fear is that matters have now progressed to the stage where the Fed’s credibility for delivering price stability is at serious risk. And, as experience teaches us, the less credible the central bank, the more painful it is to lower inflation to target.

In this post, we discuss the policy crisis and suggest how to respond. In our view, the FOMC needs a plan to raise rates quickly and substantially. For the FOMC to ensure inflation returns to its target of 2%, policymakers likely will need to bring the short-term real interest rate into significantly positive territory. Put slightly differently, we suspect that the policy rate needs to rise to at least one percent above expected inflation.

Won’t a sharp policy tightening trigger a huge recession? In our view, credibility is the key to how much pain disinflation will cause. Applying the painful lesson of the 1970s and early 1980s leads us to conclude that the FOMC now needs to show clear resolve. Inflation rose very quickly over the past year, so it may still be possible to bring it down sharply without a recession. The more decisively policymakers act, the lower the long-run costs are likely to be. Failure to restore price stability in a timely way would almost surely render this expansion disturbingly short compared to recent norms.

Talking about Tapering

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).

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….

Inflation: Don't Worry, Be Prepared

Everyone seems to be worried about inflation (see here and here). People also are concerned that the rising media salience of inflation could raise inflation expectations, leading to a sustained rise in inflation itself.

April price readings certainly boosted these worries: the conventional measure of core inflation—the CPI excluding food and energy—rose by nearly 3% from a year ago, the biggest gain since 1995. Fed Vice Chair Richard Clarida summed up the nearly universal reaction when he said: “I was surprised. This number was well above what I and outside forecasters expected.”

The experience of the high-inflation 1970s makes people prone to worrying about such things. Our reaction is different. After all, worry alone is not going to prevent a sustained pickup of inflation. Only credible anti-inflationary monetary policy can do that. To ensure that inflation expectations remain low, it is up to the central bank to make sure everyone understands how policy will respond if the latest elevated inflation readings prove to be more than temporary. As we have written before, the key is effective communications, not premature action….

Is Inflation Coming?

For more than a generation, the U.S. inflation-targeting framework has delivered impressive results. From 1995 to 2007, U.S. inflation averaged 2.1% (as measured by the Federal Reserve’s preferred index). Since 2008, average inflation dropped to only 1.5%, but expectations have fluctuated in a narrow range: for example, the market-based five-year, five-year forward (CPI) inflation expectation rarely dipped below 1.5% and never exceeded 3%.

However, the pandemic brought with it many dramatic changes. Fiscal and monetary policy mobilized, responding swiftly to the economic plunge with a combination of extraordinary debt-financed expenditure and balance sheet expansion. As a matter of accounting and arithmetic, these actions have had a profound impact on the balance sheets of banks and households, spurring dramatic growth in traditional monetary aggregates. From the end of February to the end of May 2020, broad money (M2) grew from $15.5 trillion to $17.9 trillion—a 16% jump in just three months.

Won’t the record 2020 gain in M2 be highly inflationary? We doubt it, and in this post we explain why. At the same time, we highlight the chronic uncertainty that plagues inflation. In our view, the difficulty in forecasting inflation makes it important that the Fed routinely communicate how it will react to inflation surprises—even when, as now, policymakers wish to promote extremely accommodative financial conditions….

The FOMC is coming

Having dropped to 5.1%, the unemployment rate has reached the longer-run employment goal of the Federal Reserve’s Open Market Committee (FOMC). So, starting to raise interest rates would seem to be in the cards. And, many observers expect policymakers to act soon, possibly very soon.

The key sticking point, and it is a big one, is that inflation – as measured by the personal consumption expenditure price index (PCE) favored by the FOMC – has been consistently below their stated 2% medium-term objective since early 2012.

Tightening monetary policy for the first time since 2006 requires confidence that inflation will in fact head back up (see, for example, the July FOMC statement and Fed Vice Chair Fischer’s recent comments). The difficulty is that confidence requires reliable forecasts. And, as it turns out, precise forecasts of inflation are hard to come by....

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