Behind the Fed’s slow pivot to tackling inflation
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12 min read . Updated: 15 Feb 2022, 07:27 PM IST Powell engineered an economic rescue but now has tricky task of cooling prices without hampering growth
During the first year of the pandemic, Federal Reserve Chairman Jerome Powell earned a reputation as a monetary dove, rolling out innovative policies aimed at preventing a financial and economic meltdown.
Today, he is changing into a hawk willing to be equally improvisational to tame inflation, now running at a 40-year high of 7.5%.
Whether he succeeds will go a long way to determine the future path of the economy as well as the central bank’s credibility.
The need for the about-face is partly of the Fed’s own making. Mr. Powell responded to the pandemic by doubling down on strategies developed by his predecessors to combat prolonged high unemployment and very low inflation. When the labor market healed rapidly and high inflation emerged as the bigger threat, he and his colleagues were caught by surprise.
“We’re pretty far behind the curve. That’s not where we wanted to be," said Eric Rosengren, who as president of the Boston Fed until last September had a hand in designing those policies.
In some ways, Mr. Powell’s challenge is thornier than it was at the outset of the pandemic. No Fed chairman since Paul Volcker in the early 1980s has had to grapple with inflation this high. The risk for Mr. Powell and the nation is that his fight against inflation will cause a new recession, as Mr. Volcker’s did. Historically, the Fed hasn’t been able to push down inflation without a recession.
Exactly how Mr. Powell intends to tighten policy represents an additional challenge. The Fed has both the traditional lever of short-term interest rates and a newfangled one: shrinking its vast holdings of Treasury and mortgage-backed securities. This could be especially treacherous for markets accustomed to a central bank that for the past two decades mostly used just interest rates, and tried to telegraph how fast it would raise them.
Fed officials warn they can’t provide that same predictability this time. For markets “it could be a bumpy time," said Esther George, president of the Kansas City Fed.
In less than a year, the Fed went from projecting no interest rate increases before 2024 to signaling it will raise rates at its next meeting, March 15-16, for the first time since 2018. Then just in the past week, investors have begun anticipating a half-point instead of quarter-point increase at that meeting, which would be the first one that big since 2000.
No past Fed chair has had to deal with a shutdown of the U.S.’s economy and those of trading partners, as Mr. Powell confronted. A great deal hangs on issues outside of his control, including to what extent the virus recedes, how quickly supply chains heal and how much working arrangements and spending preferences revert to pre-pandemic patterns.
Mr. Powell has been nominated by President Biden for a second term and is expected to win bipartisan backing in the Senate confirmation vote, which could come as soon as this month. The Senate Banking Committee is set to begin the process with a vote on Tuesday.
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When the pandemic hit in early 2020, Mr. Powell ran through a crisis-fighting playbook from former Chairman Ben Bernanke and then added new pages, doing things the Fed had never done before, such as making loans directly to cities, states, and businesses.
Though the worst of the financial crisis had passed by June, the economic situation was still bleak. Unemployment peaked at 14.7%, which didn’t include millions of Americans who’d left the workforce.
In August 2020, Mr. Powell led his colleagues to adopt a policy framework designed to address a problem that had long dogged the Fed and other central banks, and that the pandemic threatened to worsen: inflation running persistently below the 2% target.
Under the Fed’s old framework, it would raise interest rates pre-emptively. Rather than wait until inflation was above 2%, it would act when unemployment was falling, to prevent inflation from exceeding 2%.
The new framework rejected pre-emptive strikes on inflation. To put this new framework into action, they pledged in September 2020 to maintain rates near zero until labor-market conditions were consistent with maximum employment—which wasn’t fully defined but generally corresponds with historically low levels of unemployment—and until inflation reached 2% and headed higher.
To further hasten the fall in unemployment, the Fed would buy $120 billion in Treasurys and mortgage bonds each month. The goal was to send investors into riskier assets, buoying stocks, corporate bonds and real estate by lowering long-term interest rates. In theory, buying longer-dated securities would reduce what economists call a “term premium," or the extra yield investors demand for the risk of lending over a long term.
The Fed and many private-sector economists were caught off guard by how the economy responded as it reopened last year. Unemployment fell much more quickly than expected—to 4% last month from 5.9% in June. Wages ratcheted steadily higher as employers faced shortages of labor.
Inflation surged last spring, driven by brisk demand for goods and by shipping bottlenecks and shortages for intermediate goods such as semiconductors. Fed officials attributed the surge to idiosyncratic increases in the prices of a handful of items tied to reopening the economy, which they thought would be short-lived.
Instead, price pressures broadened. Few economists, inside or outside the Fed, imagined such a large surge in inflation when the new framework was adopted. Yet Fed officials felt compelled to hold rates at zero and continue adding to their bond portfolio to adhere to their guidance laid down for reaching maximum employment.
“That guidance, in retrospect, does not look like it was ideal," said Mr. Rosengren.
Additionally, Mr. Powell and his colleagues were slow to revise their forecasts for growth, inflation and interest rates after President Biden signed a $1.9 trillion fiscal stimulus bill into law in March 2021, though a handful of economists, including former Treasury Secretary Larry Summers, warned the spending could feed inflation. On the heels of a $900 billion measure former President Donald Trump approved at the end of 2020, that boost in retrospect should “have set their antennas quivering more than it did," said Donald Kohn, a former Fed vice chairman.
By late last summer, Mr. Powell began to pivot. In November he initiated a plan to reduce the Fed’s monthly bond buying to zero over eight months, clearing the way to raise rates by mid-2022.
But the labor market was tightening fast, and inflation pressures, rather than easing, broadened. In December, Mr. Powell said the purchases would end by March, allowing rate rises to begin immediately after.
For the central bank, it was an uncharacteristic about-face. “As the data came in, they said, ‘We were wrong.’ How often do you hear the Fed say that?" said Mr. Kohn.
Despite the quick shift, the policy response still had room to catch up, Mr. Kohn said. As recently as December, Fed officials continued to signal they would tighten monetary policy much as they had in the past: with a mild path of rate increases over the next three years. They premised that on inflation falling to 2%, even though they expected growth and unemployment to run at levels that would apply upward pressure on inflation.
“The forecast didn’t add up," said Mr. Kohn.
Mr. Powell seemed to acknowledge as much at a news conference after the Fed’s meeting last month. He hinted at a faster path of rate increases and declined to rule out raising rates at consecutive policy meetings, which hasn’t happened since 2006, or by a half percentage point at once. “I don’t think it’s possible to say exactly how this is going to go," he said.
That marks an important break from rate-rise cycles that began in 2004 and 2015, and it could make the current cycle more like 1994. That year, after a prolonged period of low, stable rates, the Fed under then-Chairman Alan Greenspan raised rates 3 percentage points in a one-year span.
The unexpectedly rapid tightening hammered bond prices more than almost any other move in the postwar era. Orange County, Calif., went bankrupt and Mexico devalued its peso, ravaging its economy. The Fed lowered rates modestly in 1995 amid fears the economy might slide into recession.
When Mr. Greenspan again prepared to raise rates in 2004, he incorporated the advice of Mr. Bernanke, an accomplished academic and then a Fed governor, who said that clearer guidance about the Fed’s goals and intentions could lead to more effective policy.
“Ambiguity has its uses, but mostly in noncooperative games like poker," Mr. Bernanke told colleagues in 2003, according to transcripts of a Fed policy meeting that year. “Monetary policy is a cooperative game. The whole point is to get financial markets on our side and for them to do some of our work for us."
At their meeting next month, Fed officials will release new projections showing how much they expect to lift rates. Thus far, their goal has been to raise them to “neutral," a level that neither spurs nor slows growth, which officials estimate is between 2% and 3% when inflation is near the Fed’s 2% target. Unlike in recent years, and a departure from Mr. Bernanke’s guidance, how fast they get there and whether they go higher remain open questions.
Officials are hoping inflation declines as supply problems ease and demand shifts from goods, where prices rose sharply last year, toward services, where inflation has been less extreme.
There’s plenty that could go wrong. Inflation might stay high because of factors outside of the Fed’s control, such as a Russian invasion of Ukraine that roils energy markets, or shipping delays made worse by pandemic-driven lockdowns in Asia. And even if prices of goods moderate this year as expected, increases in wages and rents could keep inflation elevated into 2023.
Mr. Powell has for now declined to provide so-called forward guidance about the policy path because the inflation outlook is so uncertain.
The uncertainty over inflation and lack of Fed guidance is leading to greater volatility in bond markets. Until last Thursday, officials played down the prospect of starting with a half-point rate increase or acting between regularly scheduled policy meetings.
“I prefer not to be deploying that kind of stuff if we can avoid it, and so far, I think we’ve got a smooth response to the inflation surprise," said James Bullard, president of the St. Louis Fed, in a Feb. 7 interview.
After Thursday’s report that inflation had climbed further to a 40-year high of 7.5%, Mr. Bullard changed his message, telling Bloomberg News that he would favor a bolder, half-point increase or an inter-meeting rate increase in the coming months.
His remarks accelerated the largest one-day jump in two-year Treasury bond yields since 2009 and led futures markets to bet on a half-point increase next month.
If Mr. Powell and his colleagues deliver such a move, they could be criticized for panicking. If he opts for the smaller increase, he could be criticized for not taking inflation seriously enough.
“Ideally, the Fed would come out and exert control of the policy message," including by saying it will raise rates in a fashion that doesn’t inflame fears of an emergency, said Brian Sack, who ran the New York Fed’s markets desk from 2009 to 2012 and is now the director of economics at hedge-fund manager D.E. Shaw.
Market speculation that the Fed might raise rates in between meetings, which intensified after Mr. Bullard’s remarks, fanned fears that policy isn’t well positioned to restrain the economy and bring down inflation, analysts said.
Complicating its deliberations, the Fed has more than one way of tightening policy by shrinking its bondholdings, which have more than doubled to $9 trillion since March 2020.
When the Fed shrank its holdings between 2017 and 2019, it did so passively by allowing a certain amount of securities to mature without replacing them every month. Some Fed officials, uncomfortable with having such a big presence in Treasurys, the world’s most important financial market, believe high inflation calls for a faster retreat by actively selling assets to raise longer-term rates. Ms. George, the Kansas City Fed leader, and Mr. Rosengren advocate that more aggressive path.
Most Fed officials are cool to that, at least for now. “When you’re adjusting policy substantially in other ways, introducing asset sales just complicates the path," said Mr. Sack. “There’s a risk of pouring fuel on the fire. The balance sheet is an instrument with still-uncertain effects, and you don’t want to push it too hard."
For now, that also appears to be the predominant view at the Fed. Mr. Powell said last month he wants the program to run in the background. It would function more like the rhythm section in a band, allowing the Fed to move its benchmark rate up or down if it wants to adjust policy.
Looming over this is the reaction of the markets. Stocks, corporate bonds and real estate all reached historically high valuations in part on the assumption rates would remain very low for years. Though household borrowing as a share of U.S. gross domestic product is well below levels reached during the housing boom of 2004-06, corporate debt is near a record high.
“There are people who are living in a world in which an aggressive Fed tightening—an increasing possibility here—is not an outcome they can accept, so they’re pretending it won’t happen," said Scott Minerd, chief investment officer at the investment firm Guggenheim Partners. “The places where that’s very real—cryptocurrency, tech-related companies in private equity—could be in deep trouble."
Once there’s a sharp decline in one of those sectors, that could set off volatility in other corners of the market, he said.
Mr. Rosengren said the prospect of a soft landing for the economy has diminished over the past six months because of more persistent supply shocks and workers winning higher wages to offset higher prices.
Rapidly raising rates to address the inflation problem increases the risks of a recession, he said. “If you’re raising rates rapidly, you don’t have time to see how the rate increases you’ve already done have slowed down the economy," he said.
One danger is that the Fed faces a bind where inflation only partially reverses its recent climb. That would leave officials forced to choose between accepting a somewhat higher inflation rate or forcing unemployment to rise to higher levels, risking a downturn.
“They’re saying they’re going to keep inflation in check and I believe them, but they’re suggesting not a lot of work will be necessary," said former New York Fed President William Dudley. He believes rates will need to rise to 3% or 4%, which could damage markets.
“You’re going to be a lot less popular" in that environment than the one the Fed was in during the past decade, said Mr. Dudley.
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