What the Fed "Should" Do

Normally when we write about public policy – monetary policy, taxes, spending, trade, and regulations – we mainly focus on what we think policymakers will do and the likely effects on the economy or the financial markets. For example, we now think the Fed is on a path to raise rates gradually and persistently throughout 2022, with some possibility of a rate hike of a half a percentage point along the way, as well.

But this is a far cry from what we think the Federal Reserve should do.

The Fed is well behind the curve and – in spite of raising rates by 25 basis points last week – is only getting further behind in its fight against inflation. Yes, a higher target short-term rate is an improvement in policy. But that's because it is falling behind the inflation curve at a slower rate, not because it's actually catching up.

At present, the futures market in federal funds appears split roughly 50/50 on whether the Fed will raise rates by 25 or 50 bp in May. Instead, we think the Fed should raise short-term rates to 2.0% and do it immediately. Like today.

In addition, the Fed should announce that the hurdle for an additional change to rates in the next six months is high and it will reduce its balance sheet by $100 billion per month starting as soon as possible, not only by not rolling over maturing securities but also by outright selling longer-dated securities. That pace would double the peak pace of Quantitative Tightening from the prior cycle back in 2017-19.

No, we are not being cavalier about these suggestions, nor are we making them to get attention. Instead, it's the Fed that's been cavalier about inflation risk and now has the financial markets and economy in a position where we have to obsess over its every move. Consumer prices are up 7.9% in the past year and the year-ago comparison will likely peak somewhere around 9.0% in the next couple of months. The M2 measure of the money supply has grown more than 40% since COVID started and signals persistently high inflation for years to come.