After much prevarication, the Federal Reserve (the Fed) finally initiated monetary tightening on March 16, 2022, with a disappointing 25-basis point hike. The central bank was also forced to bring an early end to its controversial asset purchase program. Looking ahead, the Fed faces an uphill battle as the headline consumer price index (CPI) inflation rate reached 8.5 percent in March 2022 — the biggest year-over-year spike since December 1981.
Overly accommodative monetary policies deployed during the past two years, along with historical levels of fiscal stimulus, have caused the U.S. economy to run hot. A broad-based surge in average price levels has pushed inflation rates to 40-year highs, and the rapid pace of job gains has caused the unemployment rate to drop to 3.6 percent.
Fed Chair Jerome Powell, in a recent speech, admitted that “the labor market is extremely tight, significantly tighter than the very strong job market just before the pandemic. There are far more job openings going unfilled today than before the pandemic … Record numbers of people are quitting jobs each month, typically to take another job with higher pay. And nominal wages are rising at the fastest pace in decades, with the gains strongest for those at the lower end of the wage distribution and among production and nonsupervisory workers.”
Despite Powell’s rosy characterization of worker pay, many Americans are struggling to maintain their purchasing power as inflation outruns nominal wage gains. In a recent op-ed, Jason Furman, former chairman of the White House Council of Economic Advisers, noted:“John Maynard Keynes argued that a hot economy raises prices more than wages because the former adjust more frequently than the latter. This may be a good description of what happened in the 1960s. …This may also describe what has happened in the U.S. economy in the past year, especially for middle- and upper-income, workers whose wages are stickier because they are generally adjusted only annually.”
Clearly, there is a need for the central bank to cool the economy to reduce elevated inflation rates. While certain supply constraints are not directly influenced by monetary tightening, a careful consideration of the monetary transmission mechanism suggests that there are multiple channels through which higher interest rates (alongside quantitative tightening) can alleviate inflationary pressures.
First, monetary tightening is likely to directly impact interest rate-sensitive sectors such as housing and durable goods. Second, higher rates will potentially generate negative wealth effects as asset prices are forced to reset. Third, tighter financial conditions will affect the availability of credit and limit risk-taking. Such developments are likely to reduce aggregate demand and generate disinflationary pressures.
By sticking with an ultra-accommodative monetary policy stance for far too long, the Fed has fallen well-behind the curve. Having forsaken the opportunity to end monetary accommodation early in 2021, and having failed to initiate monetary tightening under more favorable circumstances, the Fed is now faced with the unenviable task of having to tighten interest rates in the face of serious geopolitical uncertainties.
There are also a few practical challenges facing the Fed as it embarks on a path towards higher rates. First and foremost, the central bank appears to be underestimating the level of monetary tightening necessary to bring inflation down to the 2 percent target level. Fed officials may need to reacquaint themselves with the Taylor Principle. According to the Taylor Principle, “the central bank should raise the policy interest rate, over time, by more than one-for-one in response to a persistent increase in inflation.”
In essence, the real policy rate has to increase in order to generate an easing of aggregate demand. At present, the ex-post real federal funds rate is substantially negative, and the Fed would have to raise its nominal policy rate by considerably more than its current forecasts suggest in order to push the real policy rate into positive territory.
Alternatively, if one considers reaching the neutral real interest rate (a very conservative estimate would put it around 0.00-0.50 percent) as a potential goal for the Fed in 2022, the central bank still faces an uphill battle this year.
A second challenge facing the Fed involves its $9 trillion balance sheet. Unlike simplistic textbook narratives, the central bank no longer has the luxury of undertaking open market operations to shift its target for the federal funds rate (FFR). Instead, in the current ample reserves regime, the Fed utilizes two rate instruments – the interest on reserves (IOR) and the overnight reverse repurchase agreement rate (ONRRP) – to adjust its target policy rate. Essentially, raising the FFR target requires the Fed to also raise IOR and ONRRP.
If the yield curve were to invert, the Fed may encounter a balance sheet problem as it may be forced to pay out higher rates on bank reserves to large financial institutions even as it receives lower rates on its substantial holdings of long-dated U.S. Treasuries. This is certain to generate political backlash in Washington, D.C.
Given the Fed’s belated actions and the limitations of its policy tools, financial markets and the citizenry may have to consider the possibility that inflation will remain elevated (above the 2 percent target) for an extended period. The new normal for inflation may, in fact, be between 3-4 percent.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.