The Federal Reserve embarked last week on its long-advertised monetary tightening: a quarter-point increase in interest rates, with the suggestion of six more by the end of the year, and a plan to run down its stock of government debt (details to follow). This was widely expected and essentially a non-event.
Much more interesting was the way Fed Chair Jerome Powell explained what the central bank was doing. This was downright puzzling, and it raises some questions about what comes next.
Inflation stands at a 40-year high and keeps exceeding the Fed’s projections. Its new forecasts show inflation at 4.3% at the end of this year, 1.7 percentage points higher than it projected three months ago. Yet the policy interest rate is projected to be only 1.9% at year’s end — an increase of just one percentage point over the previous projection, and still significantly below what most economists see as the “neutral rate” (neither adding to nor subtracting from demand) of 2.5%.
Powell therefore needed to say why policy was shifting so slowly, bearing in mind that inflation has already risen further and more persistently than the Fed expected and that the Russia sanctions shock will make things worse.
Here’s a good rationale: The interest-rate plan splits the difference between economists who want to keep rates close to zero to avoid tipping a fragile recovery into recession, and those who think the Fed has let inflation run out of control and want more forceful corrective action.
There’s much to be said for this middle course. The outlook is uncertain and the Fed has to contend with upside and downside risks. In addition, if the Russia shock is mostly on the supply side, as seems likely, monetary policy should mostly ignore it, for the same reason it was right to ignore the rise in inflation due to the supply-side part of the Covid shock. Central banks, according to the standard view, should “look through” temporary fluctuations in supply.
So the message might have been: Yes, demand is trending a little high, so tightening shouldn’t wait any longer. But let’s be careful not to overdo it.
Powell didn’t strike this balance. Asked about the downside risk, he said this:
[T]he probability of a recession within the next year is not particularly elevated. And why do I say that? Aggregate demand is currently strong, and most forecasters expect it to remain so. If you look at the labor market, also very strong. Conditions are tight, and payroll job growth is continuing at very high levels. Household and business balance sheets are strong. And so all signs are that this is a strong economy and, indeed, one that will be able to flourish, not to say withstand but certainly flourish, as well, in the face of less accommodative monetary policy.
Does this kind of economy really need another year of (admittedly diminishing) monetary stimulus — or “accommodation,” as Powell calls it? In effect, he is arguing against postponing tightening yet again, as though the view that it’s already been delayed too long isn’t worth mentioning. But this view is both widely held and increasingly plausible.
Powell was directly asked whether he believed the Fed had fallen “behind the curve.” The questioner reminded him that he’d told a Senate committee earlier this month that if the Fed had known earlier what it knows now about the path of the economy, it would have begun to tighten sooner. Powell answered that perfect hindsight isn’t much help in setting forward-looking policy. That’s true, but beside the point. If the Fed, knowing what it now knows, would have tightened sooner, then it has ground to make up, and it should be raising rates by half a percentage point or more, not a quarter of a point.
Economists who think the Fed has a lot of catching up to do are entitled to be puzzled. They heard the central bank say it agrees with their analysis but for some reason isn’t going to do what that analysis demands.
One wonders whether the Fed might have acted differently last week if it hadn’t spent so much time coaching markets to expect the gentlest possible start. That seems quite likely. And the possibility draws attention to a persistent problem with the Fed’s communications.
Its commentary and projections set policy expectations too firmly — expectations that the Fed then seems reluctant to disappoint. Reading the Fed’s so-called dot-plot of future interest rates, investors penciled in six more quarter-point rises by year’s end before Powell had stopped talking. What the dot-plot projections actually say is that the Fed’s policy makers are all over the place on what should happen to interest rates. The spread of estimates for the fourth-quarter policy rate ranges from 1.4% to 3.1%, and none of these numbers, I’m willing to bet, was offered with much conviction. It’s a huge mistake to let the median estimate — 1.9%, implying six more increases of 25 basis points — guide expectations as much as it does.
When the future is uncertain — and it’s rarely been as uncertain as now — why invite investors to make false assumptions, especially when that might limit the flexibility you’re likely to need? The Fed should take a good hard look at how it talks to the markets.
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