After much dithering, the Federal Reserve (the Fed) finally began monetary tightening on March 16, 2022, with a disappointing 25 basis point hike. The central bank was also forced to end its controversial asset purchase program prematurely. Looking ahead, the Fed faces an uphill battle as the headline consumer price index (CPI) inflation rate reached 8.5% in March 2022 – the biggest year-over-year spike since December 1981.
Overly accommodative monetary policies deployed over the past two years, together with historic levels of fiscal stimulus, have caused the US economy to overheat. A generalized surge in average price levels pushed inflation rates to 40 year highsand the rapid pace of job creation has pushed down the unemployment rate. drop to 3.6%.
Fed Chairman Jerome Powell in a recent speech, admitted that “the labor market is extremely tight, significantly tighter than the very strong labor market just before the pandemic. There are far more job vacancies today than before the pandemic… Record numbers of people are quitting their jobs every month, usually to take other, better paying jobs. And nominal wages are rising at the fastest rate in decades, with the gains largest for those at the lower end of the wage distribution and among production workers and non-supervisors.
Despite Powell’s rosy characterization of workers’ compensation, many Americans are struggling to maintain purchasing power as inflation outpaces nominal wage gains. In a recent grandstandJason Furman, former Chairman of the White House Council of Economic Advisers, noted:“John Maynard Keynes argued that a hot economy raises prices more than wages because the former adjust more frequently than the latter. It can be a good description of what happened in the 1960s. … It can also describe what happened in the US economy in the past year, especially for middle-income workers and higher, whose salaries are more rigid because they are usually only adjusted once a year.
Obviously, it is necessary for the central bank to cool the economy to reduce high inflation rates. Although some supply constraints are not directly influenced by monetary tightening, a careful examination of the monetary transmission mechanism suggests that there are multiple channels through which higher interest rates (accompanied by quantitative tightening) can dampen inflationary pressures.
First, monetary tightening is likely to have a direct impact interest rate sensitive sectors such as housing and durable goods. Second, higher rates will potentially generate negative wealth effects as asset prices are forced to reset. Third, stricter financial conditions will affect credit availability and limit risk taking. Such developments are likely to reduce aggregate demand and generate disinflationary pressures.
By sticking to ultra-loose monetary policy for too long, the Fed has fallen way behind the curve. Having given up on the opportunity to end monetary easing in early 2021 and having failed to initiate monetary tightening under more favorable circumstances, the Fed now faces the unenviable task of having to tighten rates. of interest in the face of serious geopolitical uncertainties.
There are also some practical challenges facing the Fed as it embarks on a path to higher rates. First, the central bank appears to be underestimating the level of monetary tightening needed to bring inflation back to the target level of 2%. Fed officials may need to reacquaint themselves with Taylor’s principle. According to Taylor’s principle“the central bank should increase the policy interest rate, over time, by more than one to one in response to a persistent increase in inflation.”
In essence, the real policy rate must increase to generate an easing of aggregate demand. Currently, the real ex post federal funds rate is significantly negativeand the Fed should raise its nominal policy rate much more than its current forecast suggests in order to move the real policy rate into positive territory.
Alternatively, if one considers reaching the neutral real interest rate (a very conservative estimate would put it around 0.00-0.50%) as a potential target for the Fed in 2022, the central bank still faces an uphill battle this year.
A second challenge the Fed faces concerns its $9 trillion balance sheet. Contrary to simplistic textbook narratives, the central bank no longer has the luxury of undertaking open market operations to move its federal funds rate (FFR) target. Instead, in the current abundant supply regime, the Fed uses two rate instruments – interest on reserves (IOR) and the overnight reverse repo rate (ONRRP) – to adjust its target policy rate. Essentially, increasing the FFR target requires the Fed to also increase the IOR and ONRRP.
If the yield curve were to invert, the Fed could face a balance sheet problem as it could be forced to pay higher rates on bank reserves to large financial institutions, even though it receives lower rates on its substantial holdings. in long-term US Treasury bonds. This is sure to generate political backlash in Washington, D.C.
Given the Fed’s late actions and the limitations of its policy tools, financial markets and citizens may need to consider the possibility that inflation will remain elevated (above the 2% target) for a period. prolonged. the new normal for inflation can, in fact, be between 3 and 4%.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.