The Federal Reserve’s decision to raise the federal funds rate this week by 25 basis points to 0.25 percent – 0.5 percent was anticipated by investors, as the action had been telegraphed by Fed officials in advance of the Federal Open Market Committee (FOMC) meeting. The looming question now is how it will proceed in tightening policy while avoiding stagflation or a recession.
The FOMC meeting minutes confirm that officials are worried about inflation: The latest projections show most Fed officials expect the funds rate to be hiked at each FOMC meeting and to end the year between 1.75 percent and 2.0 percent, a quarter point higher than before the meeting. This news boosted Treasury yields across the maturity spectrum.
But Fed Chair Jerome Powell and other officials have yet to address a critical issue: Namely, how did the Federal Reserve fail to head off inflation before it reached a four-decade high?
This question is important for the Fed to address to ensure that it does not compound the problem. In a recent Washington Post op-ed, former Treasury Secretary Lawrence Summers contends that “the Fed has not internalized the magnitude of its errors over the past year, is operating with an inappropriate and dangerous framework, and needs to take far stronger action to support price stability than appears likely.” Summers believes the most likely outcome is stagflation in which unemployment and inflation both average over 5 percent in the next few years.
So, where exactly did the Fed go wrong?
My take is Fed officials committed several critical errors in responding to the COVID-19 pandemic.
First, they viewed the pandemic through the same lens as the 2008 Global Financial Crisis (GFC) — doubling its balance sheet to $9 trillion while lowering interest rates to zero. In fact, the pandemic was a completely different type of shock. While the decline in real GDP in the second quarter of 2020 was the steepest on record, the subsequent rebound was unusually strong as businesses reopened and unprecedented federal support helped bridge the loss of incomes by businesses and households. Consequently, financial markets functioned effectively and the stock market rebounded from a steep sell-off.
Second, the Fed unveiled a new policy approach in August 2020 in which it would tolerate a temporary overshoot above its 2 percent annual target while focusing on “maximum employment.” This meant the Fed would take into account the decline in the labor force participation rate in setting policy. But the Fed overlooked data from the Job Openings and Labor Turnover Survey (JOLTS) showing that there was a record number of job openings during 2021, as well as mounting wage pressures that signaled labor market tightness.
Third, the Fed viewed the surge in inflation in 2021 as an exogenous event that was the result of supply-chain disruptions linked to the pandemic. The minutes of FOMC meetings do not point to an extensive debate about the role that the central bank and the federal government played in boosting aggregate demand when the economy was showing signs of overheating. Nor does there appear to have been pushback among members that inflation was temporary until late in the year.
Fourth, Fed officials appear to believe that the equilibrium federal funds rate is in the vicinity of 2.5 percent – 2.75 percent. This presumes that core inflation will fall back towards the long-term goal of 2 percent per annum later this year or next and that real interest rates should be close to zero. But the Fed has not acknowledged that its inflation forecasts have been too low. If inflation were to stay above its target, it would imply that real interest rates would stay negative well into the future.
Looking ahead, it is not clear how the Fed will proceed. Its inclination is to act “nimbly” amid uncertainty about the fallout from Russia’s invasion of Ukraine. Thus, while the bond market currently is pricing in seven quarter-point hikes in the funds rate this year, the Fed could pause at any time if the economy slows or the stock market sells off markedly.
The risk is that inflation will stay elevated, and the Fed ultimately will have to boost interest rates well beyond what is priced into financial markets. A tightening in financial market conditions, in turn, could cause the economy to slow over time and lead to higher unemployment, as Summers envisions.
Beyond this, the Fed needs to consider how its policymaking has evolved over time. Namely, its predilection has been to keep rates low, which has contributed to asset bubbles, including those impacting technology and housing previously. Indeed, nearly a decade has passed since it sought to normalize monetary policy from the GFC, and policy has been operating in “emergency mode” for a good part of the past two decades.
The evolution of asset bubbles can be traced to the late-1990s, when the Fed began to respond asymmetrically to shocks: It raised interest rates gradually during bull markets and lowered them quickly during bear markets. While this strategy has been popular with investors, the Fed now finds itself in a box where it cannot continue to placate markets without risking a worse economic outcome.
Nicholas Sargen, Ph.D., is an economic consultant with affiliations to Fort Washington Investment Advisors Inc. and the University of Virginia’s Darden School of Business. He has authored three books, including “Global Shocks: An Investment Guide to Turbulent Markets.”