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Why the Fed’s words speak louder than actions
The Fed must control inflation without triggering a recession.
Eight times a year, the Federal Reserve’s Open Markets Committee meets to set the nation’s monetary policy. The committee is currently holding one of these meetings and is expected to announce its plans this afternoon.
We can expect the closed-door discussions to focus on rising inflation. The consumer price index rose by 6.8 percent over the last year, the biggest increase since 1982. The Fed prefers an alternative inflation measure known as the personal consumption expenditures price index; it’s up by 5 percent. Both figures are far above the Fed’s official 2 percent inflation target. So the Fed will need to take action to bring the inflation rate down, a process known as tightening monetary policy.
The question facing the Fed is how much to tighten. If the Fed tightens too little, inflation could continue soaring upwards. If it tightens too much, it could tip the economy into a recession.
Ordinarily, the Fed’s main lever for tightening monetary policy would be to raise short-term interest rates. But these rates have been stuck at zero since early in the pandemic, and the Fed has signalled it won’t raise them just yet. First the Fed wants to gradually scale back its program of buying billions of dollars of government bonds each month. The Fed started this phaseout, known as “tapering,” at its last meeting in November.
On one level, the main news coming out of today’s meeting will be about whether the Fed will speed up the tapering process to clear the way for rate hikes early next year. But it would be a mistake to put too much weight on these technical details. What matters more is the message the Fed sends about its longer-term strategy—and whether the markets find that strategy credible. Because in a weird way, the key to successful monetary policy is convincing markets that your policy is going to be successful.
How the Fed shapes the business cycle
Before we get into the specifics of the Fed’s current situation, it’s worth stepping back and asking why the Fed’s actions matter. In concrete terms, the Fed conducts monetary policy by buying and selling government bonds in order to change interest rates. But at a deeper level, the Fed’s job is to manage public expectations about the trajectory of the economy.
Suppose you’re thinking about buying a new car. One factor you might consider is whether you can get an attractive rate on an auto loan—something the Fed can influence directly through its interest rate policies. But that’s probably not the most important factor in your car-buying calculus.
More important will be your assessment of your financial situation—not just right now but over the next year or two. If you feel secure in your job, you’ll probably feel comfortable shouldering the extra financial burden of an auto loan. If you’re worried about getting laid off in a forthcoming recession, you probably won’t.
If a bunch of consumers all start worrying about their jobs, car industry revenues will fall. Automakers and car dealerships will have to lay off workers. Headlines about automakers getting laid off will cause even more peopeople to worry and spending to decline further. People will skip vacations, delay purchases of home appliances, and decide they can live without a kitchen renovation. That will lead to weaker sales and layoffs in those industries.
If this process continues unchecked, the result will be a recession. In this sense, a major cause of most recessions is a widespread expectation that the economy is falling into a recession.
A big part of the Fed’s job is to stop this kind of downward spiral. But how?
At the most basic level, monetary policy works by directly putting more money into people’s pockets:
Lower rates on auto loans can encourage the purchase of more cars.
Low mortgage rates will boost the homebuilding industry, which puts more construction workers to work. Low mortgage rates also put money in the pockets of anyone who refinances their mortgage or gets a new home equity loan.
A dovish Fed announcement usually triggers a rally in the stock market, making anyone who owns stock wealthier.
Low interest rates for corporate debt make it cheaper for companies to borrow money and create new jobs.
When the Fed loosens monetary policy, the dollar usually falls against other currencies, making American exports more attractive overseas and spurring growth in export-oriented sectors.
Individually, each of these mechanisms give the Fed some influence over the direction of the economy. But collectively they are even more powerful, because they give the Fed the ability to shape public expectations about the overall trajectory of the economy.
The expectations channel
When Fed Chair Jerome Powell testified before the Senate Banking Committee on November 30, he struck a hawkish note. When asked whether the Fed might accelerate its tapering of bond purchases, Powell indicated that it was likely to do so.
“At this point, the economy is very strong and inflationary pressures are high,” Powell said. “It is therefore appropriate in my view to consider wrapping up the taper of our asset purchases, which we actually announced at the November meeting, perhaps a few months sooner. I expect that we will discuss that at our upcoming meeting.”
These comments made an impression on markets. Stocks fell more than 1 percent in the first 15 minutes of Powell’s testimony. During the same time period, the yield on 5-year treasury bonds shot up from 1.08 percent to 1.22 percent. The dollar rose after Powell’s comments.
I don’t want to over-sell these movements. They’re fairly big for a 15-minute time period, but they’re still small in the grand scheme of things. But what’s interesting about them is that the Fed hadn’t done anything yet. Powell hadn’t even promised to do anything. He just signalled that the Fed was going to consider tightening more quickly. That was enough to move the markets.
The Fed doesn’t directly control the interest rates paid by homebuyers, businesses, or other consumers. Those rates are mediated through financial markets. Also, because the public pays more attention to the stock market than the Fed, the markets are a major way that the Fed indirectly shapes public perceptions of the economy.
And financial markets don’t only react to what the Fed is doing now. They also react to what the Fed is expected to do in the future: not only at the next meeting, but sometimes months or even years in the future. If the Fed’s announcements are credible, they can “pull forward” some of the dovish or hawkish impact of future announcements. That’s because asset prices change immediately in anticipation of future Fed actions.
Promises about the future can shape the present
Here’s an example. During the early years of the Great Recession, the Fed was under a lot of pressure to “normalize” monetary policy by raising interest rates above zero. Markets worried the Fed would raise rates too soon, strangling a fragile recovery. This risk made businesses skittish about borrowing money to expand their operations.
In 2009 and 2010, the Fed tried to reassure markets by stating that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” But nobody knew what “an extended period” meant, so markets didn’t take it very seriously.
In August 2011, the Fed got more specific, stating that economic conditions were “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” A year later, the Fed announced a more complex rule, promising to keep interest rates near 0 until the unemployment rate fell to 6.5 percent (at the time it was almost 8 percent) or the inflation rate rose above 2.5 percent.
The specificity of this pledge gave it greater credibility. And many economists believe that this promise substantially boosted the economy. The yield on shorter-term government bonds fell as markets became convinced that interest rates would stay near zero for at least a couple of years. More importantly, the pledge gave businesses in 2012 greater confidence that the economy will be booming in 2014, and hence that a factory constructed in 2013 is likely to pay off.
In the wake of the pandemic, economists worried that history would repeat: that the US economy would limp out of 2020 the same way it limped out of 2008. One way the Fed tried to prevent this was by changing its approach to targeting inflation.
Previously, the Fed’s goal was to target 2 percent inflation each year, regardless of what happened the previous year. In 2020, the Fed switched to targeting the average inflation rate over multiple years (the number of years wasn’t specified). This new regime meant that if inflation came in at 1 percent in 2021, then the Fed would shoot for 3 percent inflation in 2022—or perhaps 2.5 percent annual inflation in 2022 and 2023 or 2.25 percent from 2022 to 2025. The goal was to reassure markets that slow growth in one year would be offset by faster growth later, ensuring a healthy recovery overall.
But 2021 turned out nothing like 2009. Lavish stimulus spending plus dovish Fed policy allowed the economy to recover much faster—so much faster that the US actually overshot the Fed’s 2 percent inflation target.
Now the Fed is in an awkward situation. Officially, the Fed’s new average inflation targeting regime is symmetrical. That means the 5 percent inflation of 2021 should be offset by 2 to 3 percentage points of lower inflation over the next few years.
But pushing the inflation rate down this much could trigger a recession. And the longer inflation remains elevated, the more challenging this dilemma will become. If the inflation rate stayed at 5 percent in 2022, then the Fed would theoretically be on the hook for 5 or 6 percentage points of below-target inflation in the years that followed. It’s hard to imagine the Fed actually following through with that.
The need for specificity
There’s little doubt that the Fed can bring inflation under control if it tries hard enough. Even the modest actions the Fed has taken so far have started to move financial markets in a more hawkish direction. The challenge is to avoid overdoing it and causing a recession.
Scott Sumner, an economist at the Mercatus Center, argues that the Fed should look to market signals as a guide. In particular, he points to the difference between regular and inflation-protected Treasury bonds—known as the TIPS spread—as a market prediction for the inflation rate over the next few years.
Right now, markets still anticipate above-target inflation over the next five years, though this has been trending lower in recent weeks. A good approach would be to tighten until TIPS spreads shows the Fed on track to achieve 2 percent inflation.
It would also be good for the Fed to more clearly communicate its plans to the market. How quickly does the Fed want to bring inflation back down to 2 percent? What will it do if inflation remains stubbornly high? Conversely, what will the Fed do if its tightening campaign overshoots?
It would help to make the inflation targeting regime more specific. Right now, the public knows the Fed wants to bring the inflation rate down, but it has no idea what the Fed’s inflation target is for 2022, 2023 or 2024. A better rule might provide a formula that gives exact targets for each year.
Putting out hard numbers wouldn't just help to allay public fears. It’s likely to actually make it easier for the Fed to do its job. If markets are convinced that the Fed won’t allow inflation to go much above 2 percent, then the market will treat news of too-high inflation as a harbinger of tighter monetary policy, and will move asset prices in a direction that will mitigate the overshoot. The same thing should work in reverse: if inflation starts to fall below 2 percent, the market should feel confident that the Fed will ease, and respond accordingly.
This kind of anticipatory market reaction magnifies the Fed’s actual actions and helps to keep the economy on the path the Fed has laid out. But to take advantage of it, the Fed needs to send clear and credible signals about where it's trying to go.