By the end of 2021, Fed officials realized that they had made a mistake, allowing aggregate demand to grow at an excessive rate. They began to move toward tightening monetary policy. Unfortunately, they moved so slowly that there ended up being almost no tightening during the first nine months of 2021. They worried about frightening markets. This was a big mistake.
While inflation was accelerating in early 2022, the Fed was content to let short-term rates stay near zero. All the Fed did was move from “not even thinking about raising rates” to “thinking about raising rates”. Many Fed watchers wrongly thought that this represented tightening. In mid-March, they raised rates by a measly quarter point, far too little to slow the relentless rise in core inflation. Policy was still expansionary. And yet many pundits thought the Fed was overreacting, moving too aggressively.
Now we are about to pay the price for the Fed gradualism. Bloomberg just suggested that there is a 100% chance of recession next year. I think that’s too high, but the risk is clearly increasing. By not tightening aggressively at the end of 2021, the Fed let inflation get much more deeply entrenched in the economy. With even core inflation now rising, the pain associated with bringing it down will be much greater. A small recession in 2022 would have been better than a bigger one in 2023.
As Matt Yglesias likes to say, if the Fed expects to gradually raise rates by 200 or 300 basis points over the next year, it should probably do it right away. It’s like getting into a cold lake—just jump in; don’t wade in one inch at a time.
The Fed needs to stop worrying about scaring markets and focus on their core responsibilities. In the long run, the worst thing that can happen to markets is a bad macroeconomy. Get the economy right and the markets will follow. Markets like stable NGDP growth.
PS. Just to be clear, gradualism was not the Fed’s primary error. The biggest mistake was abandoning the policy of average inflation targeting. That’s what allowed inflation to accelerate in the first place. A huge unforced error, which severely damaged the Fed’s credibility.
PPS. The Guardian is still arguing that the problem is supply-side inflation, despite 9.5% NGDP growth over the past year:
“Raising interest rates isn’t working, and the Fed’s overly aggressive actions are shoving our economy to the brink of a devastating recession,” said Rakeen Mabud, chief economist at the progressive Groundwork Collaborative think tank. “Supply chain bottlenecks, a volatile global energy market and rampant corporate profiteering can’t be solved by additional rate hikes.”
The Fed and some economists maintain that demand generated by a hot labor market and higher wages are driving inflation, and higher unemployment and interest rates are panaceas. . . .
The price drops aren’t materializing because current inflation largely isn’t demand- or labor-driven as it often is during inflationary periods, said Claudia Sahm, a former Fed economist and founder of Sahm Consulting.
“High inflation is not workers’ fault, but the Fed is waging a war on US workers,” Sahm said.
Not sure I’d call the lowest unemployment rate in 53 years “a war on US workers”.
READER COMMENTS
MarkLouis
Oct 17 2022 at 3:03pm
Sure looks like gradualism is still the operative framework. As of today, 10y inflation expectations are 2.46% – no different from March 2022 when the Fed first started raising rates.
Matthias
Oct 22 2022 at 2:38am
I’m not sure this by itself proves anything?
Perhaps the market just anticipated the policy correctly?
Brett
Oct 17 2022 at 3:15pm
It kills me that folks like Sahm think the labor-side stimulus of high inflation will persist, rather than become less effective as inflation expectations anchor in. By the end of the 1970s, unemployment was starting to go up again even as inflation went up.
The supply chain and profiteering arguments are no longer plausible, either. Corporate profits are down, and the obvious supply chain clogs have mostly cleared up – the only real exception are those products still dependent on production in an area of China vulnerable to covid lock-downs.
Spencer
Oct 17 2022 at 4:34pm
The 2yr rate-of-change in long-term money flows, proxy for inflation, exceeded all prior growth rates in Nov. 2020. It has yet to fall back below that all time high. The acceleration in inflation was a given.
Total Checkable Deposits (DISCONTINUED) (TCD) | FRED | St. Louis Fed (stlouisfed.org)
Required reserves, which were set to zero, were based on total checkable deposits.
Mark Barbieri
Oct 17 2022 at 9:25pm
The Guardian isn’t the worst thing out there. I just saw an article in Forbes by John Tamny titled Despite What the Experts Told You, This Was Never ‘Inflation’
Jeff
Oct 18 2022 at 12:38am
This is what happens when you employ thousands of highly-paid professionals to develop predictive models of a system that is far more chaotic and less predictable than those modelers would like to believe. Like airline pilots who are taught to focus on their instruments in turbulent conditions, it’s comforting for Fed officials think that if they just keep their eye on their (expensively acquired and tuned) models, then everything will be OK. Unfortunately, however, the models are just not that good, because they reflect an underlying academic understanding that is incomplete and not very good. But it’s simply too cognitively jarring for the parties involved to say that in whisper tones, let alone out loud.
Scott Sumner
Oct 18 2022 at 12:37pm
There’s a simpler explanation—the Fed reneged on a promise. It has nothing to do with overly complex models. They need to target average inflation.
Thomas Lee Hutcheson
Oct 18 2022 at 10:20pm
Did it renege? DID it change its objective or did it mistake the effects that the setting of its policy instruments would have on the targeted outcomes? “Knaves” or “fools?”I hope it is “fools.” One acknowledges an error and corrects it; one confesses sin and does penance. Forward looking v backward looking.
Theodore Mavroidis
Oct 18 2022 at 3:24am
I wonder why we keep using the term “markets.” Bonds are not traded in markets in which capital flows are determined by private investors. Bond prices depend entirely on government policy and given the size of the “bond market” the government has a strong interest in propping prices up. This is a corporatist setting more like the one used in fascist economies where seemingly “private sectors” were heavily controlled by the government. Perhaps the only difference today is that the “markets” seem to have the upper hand, repeating the 2008 playbook “if we go bust, the whole country goes bust.” In the UK during the pandemic “markets” were quiet during the massive monetary expansion simply because it supported bond prices; but small impact policies like a cut in the top tax rate induced great panic in the same “markets” since any trend towards increased government deficits reduces the value of their assets (a value which is artificial in the first place). I have nothing against markets but can we please stop applying this term blindly.
David S
Oct 18 2022 at 11:45am
Scott,
I’m glad you mentioned Yglesias, because his commentary on Fed actions/inactions over the last 18 months has been exemplary. I think he was ahead of you by a little bit on urging tightening. I’m too lazy to do the research on that because I think the focus should be on what happens over the next few quarters. Will the Fed repeat Volcker’s mistake? Or, will they repeat the mistakes of 2008 except in the opposite direction? We’ll probably hit this year end with an NGDP growth rate of 8% but to have that for 2023 would be nuts.
Henry
Oct 18 2022 at 12:03pm
The interest rate upticks engineered by Paul Volcker in the early 1980s are widely credited for ending the inflation spiral of the 1970s. There was a definite economic downturn during that time. My personal pocketbook was quite vulnerable at that time, and at the time I was rather angry. I’m over the anger and recognize that Mr. Volcker felt a duty to more than just me. The Fed fund rate did get high in the mid-1970s, but didn’t stay high for very long. Volcker not only raised the rates and kept them high for a good long time but clearly sent a message that he was willing to keep squeezing despite any squealing by people like me.
Thereafter, interest rates were very low for more than thirty years, and we had enormous economic growth. What kept the inflation rate low during the years when the Fed wasn’t squeezing?
Scott Sumner
Oct 18 2022 at 12:36pm
“Thereafter, interest rates were very low for more than thirty years, and we had enormous economic growth. What kept the inflation rate low during the years when the Fed wasn’t squeezing?”
The Fed was squeezing. Interest rates are not monetary policy.
And Volcker waited far too long to tighten.
TMC
Oct 18 2022 at 2:39pm
Volker did wait too long because he did not have the political support from Carter to put us into a recession. Especially with an election coming up. Volker only had that kind of support with Reagan. I give Carter credit for appointing Volker, but he needed to follow through and allow him to execute.
jj
Oct 18 2022 at 2:22pm
An interim step towards NGDP level targeting could be price level targeting with guard rails.
The inflation target would remain 2%, but in order to ensure achieving the employment target in the case of economic disruption, average inflation will be allowed to meet but not exceed 5% (or whatever number).
This is no more unconstrained than the present dual target; in fact it has an added constraint.
nobody.really
Oct 19 2022 at 12:42pm
And I think that’s too low. I have to; I’m a contrarian.
As any good coach would tell you, the only reason we’re facing these problems is that that the head of the Fed isn’t giving 110%.
Jose Pablo
Oct 20 2022 at 3:18pm
“PPS. The Guardian is still arguing that the problem is supply-side inflation, despite 9.5% NGDP growth over the past year:”
The IMF seems to think alike … according to The Economist.
https://www.economist.com/finance-and-economics/2022/10/19/why-inflation-refuses-to-go-away
Jose Pablo
Oct 20 2022 at 3:25pm
“In the long run, the worst thing that can happen to markets is a bad macroeconomy. Get the economy right and the markets will follow. Markets like stable NGDP growth.”
That’s brilliant!
Although not enough to stop journalist (and other non-journalist) from keep saying that interest rate increases by the FED “should” reduce share prices. FED’s incompetence should be the real drag in market prices, not the FED properly doing its job of getting a stable macroeconomy.
Alan Reynolds
Nov 4 2022 at 9:57am
This discussion seems to propose using one tool (the nominal interest rate, IOR, paid on reserves at the FED) to hit two targets: the percentage change in NGDP and/or a long-term average growth of PCE inflation (like that 2% norm the FOMC “projects” after 2025).
Unfortunately, any graph of the long-term relationship between short-term policy rates and NGDP or PCE growth does not suggest an inverse relationship between the tool and the target. Switzerland and Japan do not have low inflation because they keep some interest rate on cash much higher than in the U.S. or U.K.
Irving Fisher would have expected high inflation to result in high interest rates but would not have expected high interest rates to result in low inflation.
Fiscal price level theorist John Cochrane’s seminal effort to grapple with using an interest rate tool to “fight” inflation produced a Fisherian paradox: “Uncomfortably, long-run neutrality means that higher interest rates eventually produce higher inflation, other things (and fiscal policy in particular) constant.”
Expectations and the Neutrality of Interest Rates — John H. Cochrane (johnhcochrane.com)
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