The Fed still seems to be playing catch-up on inflation, and the economy is still running hot as monetary policy remains loose.
The Fed still seems to be playing catch-up on inflation, and the economy is still running hot as monetary policy remains loose.
T he Federal Reserve this week raised the federal funds rate by 50 basis points. Media reports are quick to point out that this is the largest increase at a single Federal Open Market Committee (FOMC) meeting since 2000, and that’s correct. They often use that fact to imply that the Fed is getting really serious about fighting inflation, but we still have reason to be skeptical about the soundness of the Fed’s response, which brings the federal funds target rate to 1 percent.
First, we need some context on how the FOMC has handled the federal funds rate since 2000. In the aftermath of the Great Recession, the FOMC essentially didn’t touch the federal funds rate for years. At the end of 2015, it raised the rate by 25 basis points, which was the first increase of any kind since 2006. There have been so few rate increases in general over the past 22 years that describing this week’s hike as the largest since 2000 doesn’t really mean a whole lot.
When it does increase the federal funds rate, the FOMC has gotten into the habit of increasing it by only 25 basis points at a time. This week’s 50 basis-point increase is notable for breaking that habit. But again, the FOMC hasn’t had many chances to break that habit considering the way it has conducted monetary policy over the past two decades.
There’s also no obvious economic reason why 25 should be the “normal” number. It’s an arbitrary convention developed by the FOMC. If we’re going to do discretionary monetary policy, there’s no compelling reason why the FOMC can’t raise the federal funds rate by 67.8 basis points or 44.44 basis points. The conditions of the economy don’t move in nice, round numbers, so the Fed’s response to those conditions probably shouldn’t either.
But that’s how the Fed does things, and it did raise the federal funds rate in response to inflation, which was the right thing to do. How far did this week’s rate hike go toward getting inflation back under control?
We have every reason to believe the Fed is still behind the curve. Alan Cole gave five reasons in a blog post for Full Stack Economics. The first three relate to issues of unpredictability and lack of actionable knowledge. These problems with monetary policy are real and inescapable.
The last two reasons that Cole gives are more political. First, he writes that “it was easy to reach for convenient excuses” last year to explain away inflation without implicating the Fed’s monetary policy. The runaway prices of used cars, the computer-chip shortage, port congestion, and any number of other nonmonetary factors could be cited as leading to higher prices. Those weren’t necessarily incorrect, but the focus on them drew attention away from the Fed, which the Fed was naturally happy to indulge.
Second, there was the fight among Democrats over renominating Jerome Powell as Fed chairman. Cole points to a comment that Randal Quarles, then the Fed’s vice chairman for supervision, made on a podcast: “We would have been better served to start getting on top of [inflation] in September. . . . That was hard to do until there was clarity as to what the leadership going forward of the Fed was going to be.”
In the meantime, money has continued to get looser. Nominal GDP grew by 10.6 percent over the past twelve months, which Scott Sumner sees as a clear sign of overheating. The gap between the actual level of NGDP and the neutral level is positive and growing still. Forecasts indicate that the gap will remain positive for the rest of the year. With spending continuing to exceed the trend for that long, the hot economic conditions that are fueling inflation right now are likely to persist.
The Fed sees a “soft landing” (or, as Powell said this week, “softish landing”) as the goal. It seems “soft landing” has become the new “transitory” — a term that’s become rote without being precisely defined. Inflation hasn’t even started to come down yet, and we’re already adding “-ish” to the term.
Michael Strain reminds us that there are two negative alternatives to the soft landing, should it not come about. The first is a recession, where unemployment rises and output shrinks. Inflation would come back down, but at significant cost. The second is stagflation, where there is no recession, but inflation remains stuck above 2 percent. Strain thinks the second option is the better of the two, given the Fed’s policies right now — which isn’t to say it’s good.
Even Brad DeLong, who until now has been more sanguine about the Fed’s approach, is starting to sound more concerned. The five-year break-even rate for inflation expectations crossed 2.5 percent for the first time last week, which was DeLong’s “personal redline.” He argues that some higher inflation was worthwhile for a faster recovery (which is a completely defensible position), but now he believes “it is more likely than not that the Federal Reserve should be tightening a little bit faster and further than it is.”
The elected parts of government aren’t doing much to help the situation. Congress and the president continue to lack a strong commitment to bring spending back under control. The more that government debt increases relative to GDP, the harder it is for the Fed to raise interest rates, because doing so increases the cost of government borrowing as well.
As Scott Lincicome argues at length in his newsletter, you could be forgiven for thinking that President Biden actually wants inflation to increase, based on his administration’s policies. It’s keeping existing supply constraints — such as tariffs, shipping regulations, and domestic-content requirements — in place while adding new constraints, such as stricter environmental regulations and new union-pleasing labor rules. It’s also goosing demand through further deficit spending, subsidies, and (if it goes through) student-loan forgiveness. Restricting supply while increasing demand is a recipe for higher prices, no matter what the Fed does.
Even though the “historic” rate increase of 50 basis points is moving monetary policy in the right direction, it’s hard to avoid William Luther’s conclusion that it’s too little, too late. As Luther points out, Powell said that the FOMC is not considering 75 or 100 basis-point increases in the federal funds rate to make up lost ground. That would indicate that despite Powell’s conviction that inflation is too high and the Fed should bring it lower, the FOMC is still locked into conventions that were established during a low-inflation era. Its slowness to adjust to economic conditions could prove costly.