And to miss a golden opportunity
Making monetary policy is hard, and I sympathize with officials at the Fed who have to make very difficult and very consequential decisions under extreme uncertainty. As someone with pretty dovish views on what policy ought to be now, I have to acknowledge that the Fed remained very patient in 2021 even as inflation rose well above its target and despite intense criticism from politicians, journalists and economists. I get the arguments for responding aggressively to high inflation, and I see how hard it would be to resist them.
But hard is what you sign up for when you take a job making monetary policy. And it seems increasingly clear to me that the Fed is in the processing of making a potentially significant error.
Arguments that this inflation could become a sustained problem, as expectations become de-anchored and wages and prices spiral upward, have always looked pretty weak. They looked weak because so much of the surge in inflation has been associated with supply constraints in a few sectors of the economy and not with a surge in services costs linked to soaring wages. They looked weak because some of the key contributors to higher inflation, like soaring food and energy costs, eat into incomes and reduce the amount of money households and firms have to spend on other goods and services. They looked weak because we never had good reason to think that the underlying structure of the macroeconomy, which in the decades prior to the pandemic yielded chronic demand weakness and persistently low rates of interest and inflation, had been altered in a fundamental way by the pandemic. And they looked weak because markets never behaved in the way they ought to have if sustained high inflation were likely to become a problem.
It may seem as though none of that ought to matter given a rate of consumer-price inflation of 7%. Surely in that case the job of the central bank is to tighten and tighten aggressively until inflation returns to target, no? But if we have good reason to believe that high inflation is largely a consequence of short-lived factors, and good reason to believe that the underlying structure of the economy is one in which demand is likely to be chronically weak rather than chronically excessive—and we have good reason to believe both of those things—then no, you don’t tighten aggressively in the face of high inflation. You don’t do that because if you do there is a good chance that six months or a year down the line your policy has accidentally become strongly procyclical: meaning that it is weighing on demand and inflation at precisely the moment that other factors are already dragging those things down.
You also don’t do that because the costs of making a dovish error are substantially lower than the cost of making a hawkish error. If you tighten too little, then a year from now inflation is higher than you’d like it to be, which annoys people and imposes some small efficiency costs across the economy, but at least you have all the tools you need to address the problem. If you tighten too much then a year from now employment is lower than it otherwise would be, which is more than a mere annoyance and which is likely to involve economic costs substantially larger than those associated with an inflation overshoot. Oh, and there may not be much you can do about it, given that this Congress is unlikely to pass much more stimulus, that the next Congress is unlikely to be controlled by Democrats, and that the zero lower bound is quite likely to bind policy in the context of economic weakness.
There were thus very good reasons for the Fed to be patient last year as inflation rose, and for it to remain patient as it began the process of monetary tightening. But Fed patience seems to have run out. It has accelerated the pace at which it is tapering its asset purchases. In March it is likely to announce the first of what some suggest will be four quarter-point rate hikes this year. And it has also made clear that once asset purchases have finished it will move to shrink its balance sheet. This stance represents an enormous shift in the outlook for monetary policy in the space of just a few months. I am skeptical that the Fed will actually find itself able to go through with all of this, but if it does it will pack into about one year what took roughly four during the last tightening cycle.
In doing this, the Fed has given itself very little margin for error. If it turns out that the economy can’t handle that amount of tightening that quickly…well, we’re all in trouble. By the time the data make clear that the Fed has taken a wrong turn, the slamming of the brakes will already have had a big impact on the economy. Financial markets will provide a much earlier warning, but the Fed may find it difficult to respond to markets while actual inflation data remains above target. This sort of rushing is exactly the thing that major policy errors are made of.
It may seem strange to worry about the possibility of too little demand given that inflation is high, that wage growth is robust, that household balance sheets look to be strong, that extremely low home inventory seems likely to support a long boom in housing construction, indeed that inventories more broadly are at low levels and need to be rebuilt, and so on. But there are a few reasons to be wary. One very big one is that the American economy does not exist in isolation, but rather is part of a global economy which has some pretty significant vulnerabilities. A mad rush to tighten could very easily transform vulnerabilities into crises and so precipitate a rapid and severe tightening of financial conditions which would blow back across the American economy. A lot of economies are in rough shape after two years of Covid-19, and the tightening that the Fed now plans to pursue cannot help but cause some major problems.
We should also be aware that strong demand for durable goods and housing over the past two years likely represented some compression of spending which might otherwise have taken place over a longer time frame. That is, the fact that sales of some big-ticket items were really strong over the past 24 months does not imply that sales will also be really strong over the next 24 months; on the contrary, it gives us at least some reason to think that demand should soften. One should also take into account the fact that savings are not evenly distributed, and the households which have the highest propensity to spend may have already worked through much of what they saved (while those which haven’t aren’t especially likely to spend savings down at all). And with high energy costs eating into those robust wage gains, the prospect of sustained strong demand powered by the spending of households toward the bottom of the income spectrum is maybe not all that great.
But also, monetary policy is about coordinating expectations. If the Fed encourages people to expect a sharp slowdown in demand growth, and boy is it doing that, then a sharp slowdown in demand growth is what we’ll get, even if there are plenty of people and firms out there with money they could spend on stuff. And so in sum, the Fed has decided to rush tightening at a time when the case for a dramatic acceleration in tightening is not strong, and that has substantially raised the prospect of a hawkish error.
Even if we set the above aside, though, it seems to me that the Fed has made a really unfortunate mistake, of a broader nature. The world we were in prior to the pandemic was a secular stagnation world, in which interest rates were stuck at very low levels even after the economy had been growing for more than a decade and unemployment had fallen to 3.5%. That was a world in which chronic demand weakness prevented the economy from producing as much as it could. In 2019, most of us had lower incomes than we should have had because there wasn’t enough spending power around to make use of available economic capacity. There wasn’t enough spending power around to make use of available economic capacity, because macroeconomic policy was insufficiently stimulative. And macroeconomic policy was insufficiently stimulative because the political system cannot be counted upon to deliver enough fiscal stimulus in a timely manner, and because low rates of inflation meant that nominal interest rates never got far enough from zero to allow the Fed to respond effectively to weak demand.
This was a big problem! And it was a problem which could have been mitigated to at least some degree had the Fed opted to set an inflation target of more than 2%. The economic costs of 4% inflation relative to 2% are practically nil, but the benefits of spending less time at the zero lower bound are considerable. The Fed, despite its institutional conservatism, was sufficiently aware of the nature of this problem that it changed its policy framework, to a “flexible average inflation targeting” (FAIT) regime, through which it would actively work to push inflation above target after periods during which inflation was below target, so as to hit 2% on average. But there were two problems with this approach. One was that it didn’t seem likely to raise the background level of nominal interest rates by all that much, since on average inflation would still only be about 2%. The other was that promising to overshoot wouldn’t do squat unless the economy ever ran hot enough to raise inflation above the target—which, pre-Covid, could not be taken for granted.
Then the pandemic came along. The inflation we’ve seen over the past year has made something of a mockery of the FAIT regime, which if taken seriously implies that the Fed should now engineer a period of below-target inflation. It shouldn’t, and it seems to me that trying to craft a monetary policy framework which could easily accommodate an event like the pandemic without missing a beat is a fool’s errand. But what the pandemic did do, as some economists, like Adam Posen, have noted, is create an opportunity. It did so by generating the sustained, above-target inflation that many worried would never be achieved under the old regime, thus providing the Fed with a way to credibly raise inflation expectations and the inflation target.
The Fed is now squandering this opportunity. I understand why the Fed might be reluctant to change its framework again so soon after adopting the current one, given how much it frets about credibility. But in a world in which the pandemic hadn’t come along to push inflation above the target for a change, it’s not clear how useful or credible FAIT would have been, and in a world in which the pandemic came along and pushed inflation up to 7% it’s not particularly credible either. And while raising the inflation target before the pandemic might have seemed risky, because of what a failure to get inflation high enough might have meant for credibility, that wouldn’t be a problem now. All the Fed has to do is not tighten too much.
But the Fed is rapidly running out of time to make the switch, if indeed it hasn’t missed the opportunity already. At 2.7% or so, the five-year breakeven inflation rate is above the 2% target but down from its November peak above 3%. More disconcertingly, the five-year, five-year forward inflation rate (which is the average rate of inflation that markets expect over the period five to ten years from now) has tumbled back below 2%. It would be funny if it weren’t so frustrating: the Fed’s panicky overreaction has very nearly reached the point where the Fed is back to undermining the credibility of the FAIT regime by encouraging markets to expect below-target inflation. I mean come on. Sure, 7% inflation is no fun, but it hasn’t made me pine for the economic conditions of the 2010s.
As I said at the beginning, monetary policy is hard. It is hard and it is important. And because it is both very hard and very important, those responsible for making it need to maintain a sense of perspective. I find it disappointing and worrying that the Fed seems to have lost its sense of perspective: regarding the relative costs and benefits of overshooting versus undershooting the target, regarding the nature of the structural forces influencing demand, regarding the relationship between American monetary policy and global financial conditions, and regarding the danger of returning to a world in which the zero lower bound regularly binds policy. As I wanted them to do for so long, they tried overshooting for once. And instead of learning from the ways in which that went wrong and adjusting the framework to strengthen the long-run policy outlook, they seem to have decided that they prefer undershooting a too-low target. So it goes.