The Policy Repercussions of the Third Great Mistake Are Slowly Becoming More Apparent

Federal Reserve Chair Jerome Powell said on Friday the U.S. central bank should begin reducing its asset purchases soon, but should not yet raise interest rates because employment is still too low and high inflation will likely abate next year as pressures from the COVID-19 pandemic fade.

“I do think it’s time to taper; I don’t think it’s time to raise rates,” Powell said in a virtual appearance before a conference. “We think we can be patient and allow the labor market to heal.” That outlook, Powell emphasized, is only the most likely case, adding that if inflation – already higher and lasting longer than earlier expected – moves persistently upward, the Fed would act.

The central bank, however, is facing a delicate balancing act in its dual mandate to seek full employment and stable prices. Consumer prices have been rising at more than twice the Fed’s 2% target, but employment is still well below the pre-pandemic level.

- Reuters, October 22, 2021

As much as last year centered around the Covid-19 pandemic and its impact on the economy, the major topic of discussion in the financial markets this year has been centered around inflation, and its prospective impact on monetary policy. During the first half of this year, Chair Jerome Powell and other Federal Reserve officials were consistently adamant that the increase in prices rippling through the economy was the result of transitory factors stemming from the pandemic itself and its direct impact on the economy’s ability to deliver goods and services efficiently. Since the rise in prices was attributed to causes which would dissipate over time as the economic impact of the pandemic waned, the Fed felt justified in more or less ignoring prices while focusing exclusively on the employment half of its dual mandate. And since there remained millions fewer people working than before the pandemic, the exclusive focus on employment seemed justified.

This approach was also in line with the Federal Reserve’s new policy framework, which was announced in August of last year. This new framework was the result of a critical assessment of the decade following the financial crisis, and the persistence of below-target inflation despite low interest rates and the first use of quantitative easing in seventy years. The assessment concluded that monetary policy had begun tightening prematurely under the assumption that inflation would revert to 2% over time as the effects of the financial crisis faded, when in fact inflation subsequently remained below 2%. This not only resulted in low inflation rates and low long-term Treasury yields later in the decade, it also severely limited the Federal Reserve’s room to maneuver in the event of another downturn in the economy, since short-term interest rates remained low. The new policy framework aimed to alleviate these circumstances by reframing the inflation half of the Fed’s dual mandate to aim for an average 2% inflation rate over time, instead of maintaining a 2% ceiling. This new framework would enable the Fed to pursue its long-term inflation goal by providing more flexibility in how short-term inflation readings were reacted to.