Getting the timing right in interest rate policy is a complicated task that has plagued Fed presidents for decades.
With employers hiring, consumers spending and companies raising prices, Federal Reserve Chairman Jerome Powell is embarking on a high-risk gamble.
Powell’s bet is that the Fed can maintain ultra-low rates, even with the US economic recovery on the rise – and that it will not have to raise rates quickly to contain rampant inflation.
It is exactly the kind of bet that in the past has led some of Powell’s predecessors to miscalculate and unwittingly disrupt the economy.
Powell and the rest of the Fed’s policy-making committee plan to keep rates close to zero until almost everyone who wants a job has one, even after inflation exceeds its 2% annual target level. Faster growth increases the risk that the Fed will eventually have to respond quickly and aggressively to a sudden acceleration in prices – and potentially cause a downturn, even another recession.
Getting the timing right in interest rate policy is a complicated task that has plagued Fed presidents for decades. Arthur Burns, who led the central bank in the 1970s, is largely responsible for allowing inflation to get out of hand after yielding to pressure from President Richard Nixon to renounce further rate hikes. Critics also argue that Alan Greenspan, whose long term as president of the Fed ended in 2006, failed to raise rates quickly or sharply enough to avoid the housing bubble that triggered the 2008 financial crisis and the Great Recession.
Even President Janet Yellen’s decision in December 2015 to slightly raise the Fed’s main short-term rate, after staying close to zero for seven years, is now seen by most economists as premature. The economy slowed in part as a result.
But in many ways, Powell’s bet is unique. On the one hand, it is based on fundamental changes in the way the Fed pursues its goals. The central bank has always sought a delicate balance between its two mandates: keeping prices stable and maximizing employment.
But Powell put a lot more emphasis on jobs than his predecessors in general. He also set the Fed’s goal of maximum employment more broadly: he stressed that this includes addressing the specific challenges of low-income workers, undergraduates and people of color – something that previous Fed presidents rarely mentioned.
And the Powell Fed now aims to fulfill its price stability mandate, seeking higher inflation, after decades when the Fed struggled to keep it low. That’s because inflation has now persistently remained below 2% for almost the entire decade, since the Fed adopted this target. Very low inflation can turn into deflation, a prolonged fall in prices and wages that normally makes people and companies reluctant to spend.
“The Volcker era started the war on inflation,” said Tim Duy, chief economist at SGH Macro Advisers, referring to Paul Volcker, whose sky-high rates during his Fed presidency in the early 1980s stifled double-digit inflation , but they did have a destructive recession impact in the process. “The Powell era begins the war against unemployment and inequality. It is a dramatic change from previous policies. “
Recent economic reports have shown an increasing recovery from the pandemic recession: Americans’ income increased in March by the largest number ever recorded, driven by $ 1,400 stimulus checks, and spending increased at a healthy pace. The number of Americans seeking unemployment benefits has dropped for the third consecutive week. Consumer confidence has reached a pandemic peak. And the economy grew at a vigorous 6.4% annual rate in the first three months of the year.
In March, employers created nearly 1 million jobs, a figure never seen before the pandemic. The unemployment rate dropped to 6%; a year ago, it was 14.8%.
All of this raised concerns about inflationary pressures. Many companies, caught by surprise by the speed of recovery, are short of raw materials and parts. Procter & Gamble, 3M and Coca-Cola said they plan to raise prices to offset the higher cost of commodities like wood, sugar and grains. Supply bottlenecks are forcing factory component prices to rise.
Still, at a news conference on Wednesday, Powell showed no sign of wavering in his bet. He acknowledged that the economic outlook is improving. But he also pointed out that the recovery of the labor market is far from complete, with 8.4 million jobs lost due to the pandemic. And he reiterated that the Fed wants to continue feeding the labor market, in part to support people whose jobs are gone – waiters in closed restaurants, for example, or people whose factory jobs are now automated – and who may need to look for new jobs. .
However, it can take months or more for the unemployed to change careers. And that means the Fed may choose to maintain ultra-low lending rates for longer than it would otherwise.
“We want to get them back to work as quickly as possible,” said Powell. “This is really one of the things that we are trying to achieve with our policy.”
Minimizing the risk of long-term high inflation, Powell suggested that the recent price increases mainly reflect supply bottlenecks that will resolve as companies find alternative suppliers or raw material producers increase production.
“An episode of a single price increase as the economy reopens,” said Powell, “is unlikely to lead to persistently higher inflation year on year in the future.”
Some economists, notably former Treasury Secretary Larry Summers, have warned that low Fed rates, along with the $ 4 trillion in additional spending proposed by the Biden government, in addition to the nearly $ 5 trillion already approved by Congress, run the risk of accelerating inflation.
On Wednesday, Powell said that if inflation got out of hand, the Fed could raise its short-term rate in time to control it. Higher rates tend to cool inflation by slowing lending and spending.
But the Fed chairman clearly does not believe that a sharp rise in prices is likely. Powell is betting on the notion that Americans no longer anticipate high inflation as they did during, say, the 1970s. If consumers and businesses expect inflation to remain low, they generally do not act in a way to raise it, such as pushing for higher wages or charge customers more to offset higher supply costs. With inflation expectations under control, Powell’s thinking continues, supply bottlenecks should have only a temporary effect.
So far, anyway, the evidence suggests that Powell’s bet is working: according to the latest consumer opinion poll at the University of Michigan, although consumers expect higher inflation in the next 12 months, they only consider it temporary. In the next five years, they expect inflation to reach an average of 2.7%, little variation from the previous year.
On Friday, the government said prices rose 2.3% in March from a year earlier, according to the Fed’s preferred indicator, but most of that increase reflected a jump in volatile energy costs. In contrast, “basic” prices increased by only 1.8%.
The Powell Fed said it wants inflation to reach 2% for “some time”, to make up for the years when inflation has remained chronically below that target level. Consequently, the Fed ruled out a decades-old approach in which it adjusted rates based on inflation and unemployment forecasts. Now, the Fed wants to see evidence that inflation is accelerating before raising rates, rather than acting in advance.
This change is crucial, Duy noted. Previously, when the unemployment rate fell to a point that Fed officials feared that inflation would rise, they would raise rates and sometimes prevent or delay further job gains.
In December 2015, for example, when the Fed raised its base rate by a quarter of a point, the unemployment rate was 5.1% and inflation was only 1.3%. Yellen explained in a speech in September 2015 why he planned to do this.
“Why not postpone the rate hike until the economy reaches full employment and inflation is really back to 2 percent?” Asked Yellen, essentially envisioning Powell’s current approach. “The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial delay. “
If the Fed waits, she warned, it may have to raise rates “relatively abruptly” to slow inflation, potentially threatening the economy.
However, unemployment continued to fall for about another four years – up to the 50-year low of 3.5%. Even so, inflation has barely moved. Powell was a member of the Fed’s Board of Governors at the time.
“The result was very positive,” said Harry Holzer, an economist at Georgetown University. “Jay Powell learned a great lesson from that experience.”