The Fed’s Actions Don’t Match Powell’s Words

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.