Can the Fed Get Out of Its Own Box?

It needs to exhibit the decisiveness and deftness of its original pandemic response.

H eadlines have blared. Seven percent inflation! Highest inflation in four decades! We have been told the Fed has “the tools” to bring inflation down. The chart below illustrates how PCE inflation has been reduced in the past. The Fed’s “tools” look pretty blunt.

Never has U.S. inflation exceeded 4 percent without incurring a recession. Never has the U.S. stock market been at its current valuation without incurring a recession. Never has the U.S. housing market been at its current valuation without incurring a recession. Never. Never. Never.

So, what is the Fed’s policy positioning to meet these challenges? Former Fed governor Kevin Warsh, perhaps with poetic license, describes it as “the loosest monetary policy in the history of the world.”

Objectively, as shown in the chart below, the real fed-funds policy rate, as adjusted for the previous year’s inflation, has been lower only once, following the Arab oil embargo and recession in the early 1970s.

The other Fed policy tool, its balance sheet, depicted below, has never been larger. It is over six times its relative size during the successful economic era of the Great Moderation.

How did the Fed’s gross mispositioning occur? Former New York Fed president William Dudley provides precise answers. As part of its average-inflation-targeting strategy, the Fed somehow adopted the shortcomings of its old rearward-looking policies as an objective, pledging not to tighten policy at all until its employment objective is reached. As Dudley says, “That means a starting point for monetary policy liftoff is when the economy’s already overheating.” Driving a car while looking solely in the rearview mirror results in a lot of crashes.

Another factor Dudley cites is the Fed’s fear of provoking another “taper tantrum.” Having become gun-shy, the Fed was “worried [it] would provoke a sell-off in the bond market.” While the taper tantrum entailed financial-market volatility, the markets recovered, U.S. growth accelerated, and developing economies saw investment inflows. The Fed’s fears were unfounded.

More broadly, one wonders if the inevitable generational turnover among Fed leadership and staff has produced institutional amnesia about double-digit inflation. Those vivid firsthand memories now belong only to those in their sixties or older. The most fundamental lesson from that regrettable era is that inflation control and financial stability are not policy alternatives to stimulating employment but policy prerequisites.

Further, the current overshoot of the Fed inflation target by more than 3 percent makes a complete mockery of the Fed’s previous obsession with a 0.3 percent difference between observed inflation and the policy target. This was utter foolishness. How can it control inflation within a few tenths when it can’t control it within ten times that? Fed officials should have listened to Paul Volcker in 2018:

As I write, with economic growth rising and the unemployment rate near historic lows, concerns are being voiced that consumer prices are growing too slowly — just because they’re a quarter percent or so below the 2 percent target! Could that be a signal to “ease” monetary policy, or at least to delay restraint, even with the economy at full employment? Certainly, that would be nonsense. How did central bankers fall into the trap of assigning such weight to tiny changes in a single statistic, with all of its inherent weakness?

The Fed’s posture of maximal stimulus continues today with rock-bottom rates and only slightly reduced QE purchases. Where should it be? Monthly inflation began surging over 4 percent annualized by February 2021. The economy still had room to reach its potential, but, with rising inflation and widespread asset bubbles, the loosest policy stance appropriate for those conditions would have been neutral — a balanced, flexible position comparable to the athletic position in sports, aware of and able to move in any direction. But the Fed was facing in only one direction, away from imminent inflation.

Precisely defining a neutral position with volatile inflation is challenging. Markets, to a degree, discount the immediate past in favor of longer-term trends in forming inflation expectations. The Fed’s own expectation of a neutral rate in the long term is 2.50 percent. Market expectations are that the Fed, after fully tapering QE by March, will raise rates four or five times in 2022. If it raises rates another four times in 2023, only by that year’s end — thus three years late — will the Fed near the neutral posture called for in early 2021. (That rearview mirror again.)

Compounding the Fed’s challenge is the overhang on bond yields from the Fed’s overstuffed balance sheet. At the beginning of 2020, Ben Bernanke gave a speech citing an impressive Fed staff paper finding a reduction by 1.20 percent in bond yields stemming from the size of the Fed’s balance sheet, then about 20 percent of GDP. Now, with the balance sheet about 75 percent higher relative to GDP, the effect is likely larger. Bond vigilantes have been crushed by the Fed’s assets.

The effect of this balance sheet overhang on policy was evident in 2019, as the Fed had to end its tightening following recovery from the great financial crisis. The presumed neutral rate of 2.50 percent was above bond rates, inverting the yield curve, possibly threatening recession. The Fed had to back off what it thought was neutral by nearly a full percentage point.

Another problem the Fed has, though, is that reducing its balance sheet to normalize interest rates may negatively affect risk assets such as the stock market. The chart below shows the close connection between central-bank balance sheets and equity values.

The contraction of Fed assets during 2018 accompanied a 12 percent decline in the stock market, the worst downturn in the period prior to the pandemic.

The tight correlation between equity values and the Fed’s balance sheet is illustrated by the market downturn since 2022’s beginning. At that time, the U.S. Treasury increased its deposits at the Fed by over $600 billion, which is equivalent to the Fed’s reducing its assets by that amount. The broad Wilshire 5000 index is down 7 percent in that time.

So, the Fed has boxed itself into a great conundrum. After being caught flat-footed in a maximally loose position with high inflation, it can’t continue fueling inflation, so it must lift rates, but its ability to do so is limited by its bloated balance sheet, reduction of which could crater asset markets.

There may be a way out of this policy box if the Fed can accelerate balance-sheet reduction with transactions outside the financial markets. The ECB provides an example. Europe relies heavily on financing businesses through banks rather than the capital markets that predominate in the U.S., so, in addition to open-market securities purchases as done by the Fed, the ECB utilizes direct lending to banks as part of its monetary stimulus. As shown in the chart below, direct loans and other ECB assets excluding securities have much less effect on asset markets as measured by stock indexes.

The correlation of ECB assets excluding securities with stock-market indexes is less than a third that of the ECB securities portfolio.

The Fed can work with the U.S. Treasury to accomplish an off-market exchange of securities in its portfolio for deposits held at the Fed to soak up unneeded liquidity in the financial system and normalize markets without destabilizing them. It can focus first on the $1.5 trillion of excess funds outside the banking system in reverse repos, then on the unnecessary component of $4 trillion in reserve deposits held by banks. To provide liquidity for Treasury securities exchanged, the Treasury can cancel the Fed’s holdings and issue new securities similar to its new market issues.

The Fed has made a major mistake in having its positioning so far out of line with appropriate policy. Whether this mistake becomes catastrophic will depend on the Fed’s exhibiting the decisiveness and deftness of its original pandemic response instead of its sluggish recognition of and belated reaction to the new economic reality. Longer-term, the Fed should recognize this serious error as an indictment of its current policy framework and implementation. Policy that worked historically during the Great Moderation was balanced, as reflected by a Taylor rule, with the fundamental recognition that controlling inflation and avoiding financial disturbances are essential to boosting employment.