It’s a scary situation if there’s no middle ground on policy for the world’s most powerful central bank.
After last week’s red-hot U.S. consumer price index reading of 6.2%, debate around what the Federal Reserve should do about inflation has reached a fever pitch. There are two prevailing schools of thought:
The Fed should do nothing.
The Fed should speed up the pace at which it gradually tightens monetary policy.
Some of those who side with view No. 1 argue that taking path No. 2 would choke off the swift economic recovery and leave millions of Americans unemployed. This, in effect, assumes the world’s most powerful central bank has a binary decision between sitting on its hands or throwing the U.S. into a downturn.
That kind of framing seems misguided at best. Tim Duy, chief U.S. economist at SGH Macro Advisors, put it this way: “It’s not a choice between a recession or zero rates forever.” Indeed, it’s time for the Fed to start contemplating how to tread a middle ground if officials continue to be wrong about inflation.
It’s true that as part of the central bank’s new framework, it pledged to leave interest rates near zero until the labor market reached “maximum employment.” But that’s an intentionally vague threshold that provides ample wiggle room and was created with the post-2008 economy in mind, when sustainable inflation was a mirage. The quits rate, wage growth and job openings all suggest a tight U.S. labor market, and certainly one that wouldn’t suddenly crumble beneath a fed funds rate that’s 50 basis points higher.
In fact, a couple of interest-rate boosts from the Fed would still leave the central bank in a historically ultra-easy policy stance when considering the current pace of inflation. The fed funds rate adjusted for headline CPI is about -6%, the lowest on record. Longer-term U.S. real yields remain near all-time lows as well. Measured this way, no previous Fed has ever been so willing to look through price pressures. There’s room to maneuver, yet a modestly accelerated tightening path — say, winding down monthly bond purchases by March and creating the option to raise interest rates quarterly, as St. Louis Fed President James Bullard suggestedon Tuesday — is seen as unconscionable.
The uncomfortable truth for Chair Jerome Powell, who clearly wants to be dovish, is that the increase in inflation and expectations for future price growth is exactly what he said he was hoping for when unveiling the new framework in August. Thereason he wanted to push those upward? So the Fed would have the scope to raise interest rates. By central bankers’ own estimates, the “neutral” fed funds rate that’s neither accommodative nor restrictive is 2.5%. That’s a long way from zero.
Those who say the Fed should do nothing argue that inflation will ultimately prove to be transitory, even though policy makers have been way off in their forecasts for price pressures this year. In March, the median estimate for inflation as measured by the personal consumption expenditures index was 2.4% for this year. That was raised to 3.4% by June and 4.2% by September. By contrast, the median for 2022 has only increased to 2.2% from 2%. Central bankers are holding out hope that they’ll be right — if they’re not, as they haven’t been in recent months, they will probably only adjust expectations when their backs are against the wall.
“We need to take it very seriously, but my view is we also need to not overreact to some of these temporary factors even though the pain is real,” Minneapolis Fed President Neel Kashkari said Sunday on CBS’s “Face the Nation” about the pickup in inflation.
Again, this feels like a strawman. Few are arguing for anything that would constitute an overreaction. Even those who lean hawkish, like former New York Fed President William Dudley and former Richmond Fed President Jeffrey Lacker, aren’t pushing for a Paul Volcker-like approach to combat inflation by shocking markets and jacking up interest rates. Powell raised the idea of “risk management” as a principle for the central bank; the prudent move now is to be humble about the post-pandemic economy and retain the flexibility to adjust policy more quickly if necessary, rather than locking into a preset course of winding down bond purchases through June.
If the specter of gradually raising interest rates from near zero is enough to cause a market panic, perhaps the Fed should take that as a sign that the financialization of the American economy has gone too far. During the last tightening cycle, equities plunged in late 2018 before the central bank could even fully reach its 2.5% neutral rate, forcing a hard pivot to rate cuts. It’s possible that after the recent sharp run-up in risk assets, investor sentiment would sour even sooner. If the Fed means what it says and wants to conduct monetary policy away from the zero lower bound, leaving stocks and credit markets hooked on stimulus isn’t the way to do it. When my Bloomberg Opinion colleague Matt Levine starts a column by saying “the basic issue is that right now everything is dumb,” and virtually everyone agrees, something is wrong.
Speaking of the absurd: It’s not great when central bank policy is compared to a British political satire sitcom. But one particular scene from “Yes, Prime Minister,” on a four-stage strategy to crisis management, does seem to capture the messaging on inflation (you can quibble with which one we’re in right now):
“In stage one, we say nothing is going to happen.”
“Stage two, we say something may be about to happen, but we should do nothing about it.”
“In stage three, we say that maybe we should do something about it, but there’s nothing we can do.”
“Stage four, we say maybe there was something we could have done, but it’s too late now.”
Ideally, central banks around the globe could begin to rein in the speculative excess and show they’re not asleep at the wheel. As Morgan Stanley Chief Executive Officer James Gorman put it last month: “You’ve got to prick this bubble a little bit.”
The consequences of doing nothing are already showing up in the $22 trillion U.S. Treasury market, which the Fed is supposed to ensure functions smoothly. Instead, the world’s biggest bond market is being whipsawed by the most volatility and least liquidity since the onset of the pandemic, in no small part because even the most sophisticated macro hedge funds can’t seem to get a handle on central bankers’ reaction function.
For now, bond traders are back to betting that policy makers will pivot to tightening. The five-year Treasury yield is near its highest since 2020, with the breakeven inflation rate through 2026 soaring to 3.2%, the highest on record. Even the long end is starting to weaken, with 30-year yields breaching 2% this week and breaking through key moving averages. That doesn’t yet qualify as a Taper Tantrum 2.0. Central bankers haven’t budged, with Richmond Fed President Thomas Barkin even repeating Powell’s strange message that policy makers will “be patient, but we won’t hesitate.”
Market onlookers, on the other hand, are more quickly shifting their tune. Call it being data dependent.