Fed misjudged inflation, Powell’s last fight
Source: Liu Qian, Zhu Xi
If the Fed creates a tsunami in markets, they could be criticized for panicking. If they don’t raise rates enough, they could be criticized for not doing enough to deal with inflation. Whether Powell succeeds will profoundly affect the future direction of the economy and the credibility of the Fed.
In 2020, when the pandemic broke out, Federal Reserve Chairman Powell launched a series of ultra-easy policies aimed at preventing financial market meltdowns and recessions, including interest rate cuts, QE and other stimulus policies, including policies that provided loans directly to cities, states and businesses The measure, the first introduced by the Fed, is considered dovish. The economic backdrop at the time was that U.S. unemployment was very high and inflation was very low.
Subsequently, the U.S. labor market recovered rapidly, the unemployment rate fell faster than expected, wages rose steadily, and high inflation gradually became a bigger threat, which caught Powell and his colleagues by surprise. Now, in response to high inflation, Powell and his colleagues are turning hawkish. In less than a year, the Fed has gone from not expecting to raise rates until 2024, all the way to raising rates in March. And just last week, the market even expected the Fed to raise interest rates by 50 basis points in one go in March.
Behind the rapid policy shift is a difficult situation for the Fed.Well-known American financial mediaPublished a long analysis article titled “The Fed’s misjudgment of inflation, can Powell reduce inflation without causing a recession?” End-August-June 2012) published a forward-looking article before it was announced and triggered a trillion-dollar market volatility.
Powell’s challenge
In some ways, Powell’s challenges are tougher now than they were in the early days of the pandemic. Not since the early 1980s has a Fed chairman battled such high inflation. The risk for Powell is that his fight against inflation will lead to a new recession, as former Fed Chairman Volcker did. Historically, the Fed has been unable to keep inflation down without triggering a recession.
How the Fed will tighten monetary policy is an additional challenge. The current Fed tightening methods include: adjusting short-term interest rates and shrinking the balance sheet. The Fed’s way of shrinking over the past 20 years has only been to adjust short-term interest rates, and for markets that are only used to that way, the additional way of tightening — shrinking the balance sheet — can be extremely dangerous.
When the Fed reduced its balance sheet between 2017 and 2019, it did so passively by allowing a certain number of securities to mature without being reinvested each month. This time, however, some officials support shrinking the balance sheet through outright selling. For now, though, most officials, including Powell, don’t support such aggressive tightening.
If the Fed creates a tsunami in markets, they could be criticized for panicking. If they don’t raise rates enough, they could be criticized for not doing enough to deal with inflation.
Former Boston Fed President Rosengren said the odds of a soft landing for the economy have diminished over the past six months as supply shocks become more protracted and workers receive higher wages to offset higher prices. Raising interest rates quickly to address inflation increases the risk of recession. If rates are raised quickly, there is no time to see how the already done rate hikes slow the economy.
Former New York Fed President William Dudley said rates would need to rise to 3% or 4% to keep inflation in check, which could hurt markets.
Whether Powell succeeds will profoundly affect the future direction of the economy and the credibility of the Fed.
Fed misjudges inflation
The above thorny situation starts with the Fed’s misjudgment of inflation.
U.S. inflation soared last spring due to high demand for goods and transportation bottlenecks and shortages of intermediate goods such as semiconductors. Fed officials attributed this to the reopening of the economy, ruling that inflation was temporary.
In September, the Fed revised its policy framework, pledging to keep interest rates near zero until the labor market reaches maximum employment. Under this framework, inflation is allowed to reach 2% and move higher.
However, it now appears that inflation is a broad sense. Few officials anticipated this when the Fed unveiled its new framework last September. Fed officials’ forecasts for economic growth, inflation and interest rates lag behind reality.
Subsequently, in the face of the rapid tightening of the labor market, inflationary pressures expanded rather than eased, and the Fed’s policy quickly turned. It’s an unusual shift for a central bank. When the new data came out, the Fed said “we were wrong”. Rosengren later said that in retrospect, the September guidance did not look ideal. Former Fed Vice Chairman Donald Kohn said, “Do you hear the Fed say that a lot?”
Despite the policy shift, the market generally believes that the policy has not kept up with the actual situation. Powell seems to think so too. In a press conference last month, he hinted at a faster path to rate hikes and refused to rule out a continuation of rate hikes (back-to-back hikes) at adjacent policy meetings, or even a 50% hike at one meeting. possibility of a basis point.
U.S. media commented that such continued interest rate hikes may make the current cycle more like 1994. That year, after a long period of low and stable interest rates, then-Federal Reserve Chairman Alan Greenspan raised interest rates by 3 percentage points over the course of a year. But the Fed moderately lowered interest rates in 1995 amid fears that the economy could slip into recession.
The Fed can’t control
Right now, many things are out of the Fed’s control, including the issue of the virus, the impact of the situation in Russia and Ukraine on energy markets, the speed at which supply chains can recover, delays caused by the pandemic in Asia, and the extent to which work arrangements and spending preferences have returned to pre-pandemic levels. mode, etc. The analysis believes that even if commodity prices slow as expected this year, rising wages and rents may keep inflation on the upward trend into 2023.
Unpredictability of future policies
Back in 2004, when Greenspan was preparing to raise rates, he took the advice of Bernanke, who would become Fed chairman a few years later. Bernanke believes that clearer guidance on the Fed’s goals and intentions could make policy more effective. “Monetary policy is a cooperative game. The key is to get the financial markets on our side and let them do some of our work for us.”
This time around, however, Powell declined to provide so-called forward guidance on the policy path because the outlook for inflation is so uncertain. This is different from how the Fed has operated in recent years. Fed officials have previously warned that they will not be able to provide the same predictability on the policy path this time around as they have in the past.
For markets, the unpredictability of future policies means a rough period. The recent hawkish speech by St. Louis Fed President Bullard triggered a huge shock in the US bond market, which is a good microcosm. (Wall Street News)
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Responsible editor: Tang Jing