Cut the Fed some slack
Financial conditions have tightened around 125bp since last year on the strength of the Fed’s forward guidance alone, long before any hikes have even materialised, showing that the markets are indeed highly anticipatory and responsive towards the Fed. On the other hand, many today doubt the responsiveness of the markets and are not even sure whether a series of 25 or 50bp hikes would be enough to tame this particular episode of inflation.
Forward guidance and Fed credibility go hand in hand, as guidance will not be taken seriously without credibility. Forward guidance is when the Fed provides information about its future monetary policy intentions based on its assessment of the outlook for price stability. However, the strength of this credibility depends on the cumulative past performances of the Fed, with the greatest weight placed on the Fed’s management of the most recent economic trials. This credibility diminishes if the Fed missteps and “market memory” retains these perceived Fed missteps when measuring out their responses. Hence, credibility constantly needs to be reaffirmed with successful actions.
The actions required of the Fed differ throughout time. Pre-pandemic, its goal was to maintain a flexible average interest rate target. Now, in the post-pandemic period, if we could already call it that, the Fed’s main focus is on cooling a sizzling-hot inflation into submission to a lower, more sustainable figure. The urgency stems from changing the new inflation figure before it becomes dangerously entrenched into the economy and de-anchors inflation expectations.
The need for the Fed to act may tempt the institution to hike aggressively to show that it means business, but this must be tempered with the knowledge that in the long run, the US economy is fighting against struggling productivity and an ageing workforce. The problem for the Fed is therefore one of deflation and staying off the zero lower bound, hence avoiding the fate of the Bank of Japan. It’s such a looming problem that the current high inflation might even be seen for some as an opportunistic exercise to achieve the 2% target, when for so long this target has been undershot.
The Fed’s inflation dashboard is busy flashing red with lingering supply problems, hot wage growth, strong rent growth, very high year-on-year core PCE or CPI and rising short term inflation expectations. In the meantime, everyone is hoping that this will be assuaged by sufficient global goods production, unhindered by global shutdowns and counting on American workers to return to the labour force once Covid isn’t so scary and their financial cushions are spent. Needless to say, the Fed is juggling and keeping eyes on many data balls in the air.
But we are all watching the datapoints as they come in - the difference for the Fed is that based on the forest of data, they have to make some calls so that market participants can all agree on our common direction to safely go through the forest and synchronise the speed that we would collectively take. Keep in mind that the Fed also has to look through temporary shocks and anticipate the long term trend.
As the Fed staff are not fortune tellers, the next best thing they have is to check for trends in the data and form forecasts based on reasonable assumptions. This self-imposed data dependence discipline however means that market participants must be prepared to be more flexible in their responses, taking their cues from the Fed when the need to pivot arrives.
Market participants must be willing to forgive the Fed for its lack of certainty rather than punishing the institution by spreading doubt on social media and withdrawing trust. Really, it is to the advantage of participants that trust is maintained so that consensus can more easily be achieved and further stability of the economy is enhanced.
When it comes to unemployment, the Fed has more credibility focusing on it when the economy is weak. The population experiences instant relief as easing allows for more job creation and yet any costs in higher inflation come later. In a strong economy and the Fed tightens, the risks to employment manifest quickly, whereas the benefits of stable inflation come later. Recently, there are other considerations that the Fed also takes into account, such as trying to maximise employment in order to be more inclusive of minorities.
What about now when the economy is hot and in recovery mode? Conditions in the labour market, based on the 5.3 million gap between total available jobs and workers are the most overheated since the end of World War II (Goldman Sachs). What is the Fed trying to achieve by hiking today? The answer is that it hopes to moderate expectations of growth, and one of the ways is to force firms to be less ambitious in their expansion plans.
The Fed thus far believes that it can tighten financial conditions sufficiently such that growth returns to trend without starting a recession. It must be cautious in doing so because historically, increases in the unemployment rate of more than 0.3% from its trough have led to a recession (Hatzius). The probability of recession right now is a tug-of-war between the anti-growth side in the shape of reduced fiscal support (fiscal drag), and on the pro-growth side where consumers are spending out the rest of their savings, helped along by the greater opening of the service sector.
There is the thinking that at every point in time, there is a clear cut, correct action that the Fed should be taking. In reality, the situation is always a trade-off, a balance of risks and a constant rethinking of which fire needs to be put out first. Judging the Fed’s actions in retrospect and in this light is highly unfair. To add, as much as we’d like to think that there is central bank independence, the needs and desires of the public are expressed loudly and the political will of the government that follows such public outcries do influence Fed meetings and decisions.
Monetary policy works mainly through the private channel, hence there are limits to what it can achieve. Extending the connection between the central bank and the government, we have to understand that fiscal policy, too, will have to do much more than its current share. From Francesco Bianchi’s 2021 paper, “A coordinated strategy between the monetary and fiscal authorities works as an automatic stabiliser, reducing the likelihood of a disastrous conflict between the two authorities.”
It is time we stop thinking of monetary policy as a standalone and start thinking of monetary-fiscal policy as the yin-yang of the country’s economic stability.