Fed Tightening Is Too Little, Too Late

T he Federal Reserve is finally starting to course correct. On Wednesday, the Federal Open Market Committee (FOMC) decided to raise its effective-federal-funds-rate target range by 50 basis points and begin the process of shrinking its balance sheet. The decision comes more than a year after prices first exceeded the level consistent with the Fed’s 2 percent average-inflation target. In March, the price level was 4.6 percentage points higher than it would have been had the Fed hit its target.

In a press conference immediately following the FOMC meeting, Fed chairman Jerome Powell acknowledged that “inflation is much too high” and that the Fed is “moving expeditiously to bring it back down.” He told reporters that the central bank “has both the tools we need and the resolve that it will take to restore price stability.” When pressed, however, Powell’s resolve appeared to be lacking.

When asked whether the FOMC would have the courage to endure a recession if it were necessary to reduce inflation, as Paul Volcker had done, Powell expressed admiration for his predecessor but demurred:

I would phrase it this way: he had the courage to do what he thought was the right thing. That’s what it was. It wasn’t any particular thing. It was that he always did — he always did — what he thought was the right thing. . . . So, that’s the test. It isn’t: will we do one particular thing.

Having sidestepped the question, Powell reiterated the Fed’s commitment to bringing down inflation. “We see restoring price stability as absolutely essential for the country in coming years,” he added.

Recent experience would suggest otherwise. The Fed was slow to acknowledge the inflation problem — and then slow to act. It has made modest moves so far, it is not seriously considering a more aggressive approach should its current actions fall short, and it does not intend to bring prices back down to a level consistent with a 2 percent growth path, as its average-inflation target would seem to require.

When inflation began to pick up last year, Powell and other Fed officials initially wrote it off as transitory. It is hard to fault them for that. The price level had grown slowly over 2020, and so some catching up was in order. Moreover, by July, inflation in excess of what was required to achieve its 2 percent target appeared to be attributable to temporary supply disturbances.

Yet that position became harder and harder to justify over time. The price level — already well above the level consistent with the Fed’s target — grew 5.06 percent in October. Unemployment had fallen to 4.6 percent and, despite lingering supply disturbances, real output had largely recovered. The available data clearly suggested the economy was over-producing given its reduced potential. Still, the Fed was reluctant to recant and act.

By December, Powell had retired the word transitory and plotted a course “to prevent higher inflation from becoming entrenched.” But that course was based on very optimistic projections of inflation, which soon became clear. When the FOMC met in March, the median member’s projection of inflation for 2022 increased from 2.6 to 4.3 percent. Did this revision coincide with a larger-than-projected rate hike or an accelerated tightening schedule? No. Again, the Fed failed to course correct.

Now, with inflation on track to exceed 7 percent for the year and FOMC members likely to revise their projections up again in June, the Fed is finally taking a more aggressive stance. Powell reported a “broad consensus” among FOMC members to consider 50-basis-point hikes at the next couple of meetings. When asked whether the Fed might consider a 75- or 100-basis-point increase, Powell said “it is not something the Committee is actively considering.”

Whatever the FOMC decides to do over the next year, one can be reasonably confident it will not be enough to bring prices back down to a level consistent with the Fed’s average-inflation target. In March, FOMC members projected inflation would remain elevated through 2024 and return to 2 percent thereafter. There is no indication that the Fed will bring inflation down below 2 percent temporarily, in order to achieve 2 percent inflation on average — and plenty of evidence to the contrary. Bond markets are currently pricing in around 2.66 percent inflation per year over the next ten years.

The Fed took too long to acknowledge inflation was largely demand-driven. It took too long to respond and too long to revise its response when the data turned out to be worse than it had projected. We should not be surprised that it now looks likely to do too little.