Can the Fed regain its credibility?
Even as the U.S. inflation rate surges, the Federal Reserve (the Fed) continues to engage in large-scale asset purchases (they are scheduled for a belated end in March). The juxtaposition of the Fed debating quantitative tightening (QT) even as it persists with quantitative easing (QE) highlights the inherent absurdity of the central bank’s monetary policy stance.
As previously noted, both the Fed’s appraisal of the ongoing economic recovery and its forecast of underlying inflationary trends have proven to be consistently off the mark. Furthermore, by sticking with ultra-loose monetary policy for far too long, the U.S. central bank has exacerbated economic and financial distortions, and heightened the risk of a hard landing.
There is a potential risk that further delays may lead to inflation expectations becoming unmoored — input and wage price setters go from seeking to retain real purchasing power (by trying to catch-up with past above-trend inflation) to demanding additional hikes to compensate for expected future inflationary surges.
What can the Fed do to overcome its past errors and regain credibility? There are two crucial actions that the Fed can take in 2022 to restore public confidence and work towards attaining its dual mandate objectives (maximum employment and price stability). Given that the labor market is already at or near full employment (low unemployment rates, record levels of job openings and quits, widespread worker shortages and rapid wage growth), the Fed’s task should center primarily on returning inflation to its 2 percent target level.
The first course of action for the Fed should involve two quick 50-basis point rate hikes (a first hike following the March Federal Open Market Committee meeting and a second one after the June FOMC meeting would be ideal). Federal Reserve Bank of St. Louis President James Bullard recently proposed such a move in light of the magnitude of the ongoing inflationary shock.
There are several practical reasons for going big early. U.S. real interest rates have been stuck in negative territory for much of the past year even as the economy grew at the fastest clip since 1984. As Harvard economist Larry Summers recently observed “I am rather skeptical that interest rate increases that will still leave real interest rates negative – that is, interest rates below inflation rates – will be sufficient to contain inflationary pressures.”
Clearly, the Fed has substantial ground to make up and two quick 50-basis point rate hikes will go a long way towards restoring order. Another reason for going big early has to do with the monetary policy transmission mechanism. At present, two interest rate-sensitive sectors – housing and durable goods – are facing especially significant supply-demand imbalances, and they will benefit from an easing of demand pressures.
If the Fed manages to act bravely and pushes the federal funds rate target towards the 1.00-1.25 percent range before July, it can then promise to hold-off on further rate hikes until year end. This should give the Fed the opportunity to focus on a second course of action during the 2022H2 — aggressive QT. Additionally, it allows the Fed to calm investor nerves and avoid potential turmoil in financial markets that might threaten to blow back on the real economy.
QT basically refers to the full or partial unwinding of QE. It involves a reduction of reserves from the central bank’s balance sheet either by undertaking sales of assets that were acquired during various rounds of QE and/or by allowing balance sheet runoffs (not reinvesting the proceeds from maturing securities).
The rationale for engaging in an aggressive timetable for QT (a reduction of $1.5 trillion or $2 trillion by end of 2023) is clear. A potential concern arising from recent bond market volatility is that aggressive monetary policy tightening will lead to a rapid flattening of the yield curve, which is then quickly followed by an inversion of the yield curve (by the end of 2022 or early 2023). Inverted yield curves have been highly accurate predictors of recessions in the past.
By engaging in aggressive QT, the Fed can limit yield curve flattening and delay the onset of yield curve inversion. By increasing the supply of (and/or reducing the demand for) long-dated Treasury securities, the Fed can steepen the yield curve (especially the 2s10s yield spread).
Despite calls from several quarters for a go-slow approach on the rate hike front, the Fed should act boldly in the short-run. There is limited rationale for maintaining near-zero interest rates and a $9 trillion balance sheet when inflation rates are at 40-year highs. An ultra-accommodative policy stance is not going to magically bring back marginalized groups into the labor force nor is it going to solve America’s structurally-driven inequality problems. A delayed response, however, does raise the prospect for much harsher actions in the future.
By acting quickly and aggressively, the Fed enhances the possibility that the required terminal rate (the expected endpoint for the rate hike cycle) is within its forecasted range. There is growing evidence that elevated inflation levels are being built into forecasts for the next two years and a go-slow approach may box the Fed into a corner — it may be stuck facing an unpleasant scenario of having to raise rates even as the economy is slowing down (the dreaded stagflation-type situation). Early Fed intervention will also reduce the need for misguided or ill-advised fiscal measures.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.