About the Author: William English is a professor in the practice of finance at the Yale School of Management. He previously served as Director of the Monetary Affairs Division at the Federal Reserve Board.
The Federal Reserve faces two related challenges. First, how can it best calibrate the pace and magnitude of future rate hikes, as well as the timing of any subsequent rate cuts? And second, how should it communicate with the public about policy perspectives?
Last week, the Federal Reserve raised its federal funds rate target by 75 basis points, bringing the total increase since March of this year to almost 4%. In his post-meeting press conference, Fed Chairman Jerome Powell noted that ongoing rate hikes would remain appropriate for some time, but the pace of policy tightening would likely slow fairly quickly.
Conceptually, the Fed would like to tighten policy until it is tight enough to ease pressures in labor and production markets and return inflation to a path back to 2% over the medium term. But in practice, calibrating the appropriate degree of tightening is difficult, partly because of the lags with which monetary policy affects the economy. While actual and anticipated changes in monetary policy affect financial markets very quickly, the effects of these changes in financial conditions on spending take time. Many households and businesses will not immediately understand changes in financial markets, and they have habits, commitments and planning processes that slow down the resulting adjustments in their spending. In addition, some expenses, for example, to build a factory, simply take a long time and are expensive to stop before completion. The expenditure effects then influence the degree of slack in the production and labor markets, which in turn affect inflation over time, but only when prices and wages are gradually adjusted.
Because of these delays, policy makers need to be forward-looking and base their policy decisions on models and forecasts. But the Fed is likely less confident in its forecast given economists’ lack of experience with the effects of global pandemics on the economy, the difficulty of assessing the timing and extent of the effects of the unprecedented fiscal measures taken in response to the pandemic, and the disproportionate geopolitical risks weighing on the economic outlook. In addition, models of the inflation process have proven unreliable over the past 18 months, with inflation consistently above Fed forecasts. These uncertainties make decisions on policy calibration more difficult and subject to considerable revisions, as we have seen this year.
A further complication is that the Federal Reserve rightly takes a risk management approach, aiming to balance the costs of too little or too much tightening. As President Powell noted in his Jackson Hole speech in August and reiterated at his press conference last week, the Fed views the costs of doing too little to be considerably higher than those of doing too little. ‘to overdo. Although excessive tightening would incur significant costs, if the economy slows to an undesirable extent, policymakers can ease policy to help get the economy back on track. However, if the Fed tightens too little now, inflation will remain well above target for longer, increasing the risk that excessive inflation becomes embedded in wage and price setting behavior. The costs of entrenched high inflation would be very large: the Fed would have to tighten monetary policy significantly, potentially triggering a deep recession, to bring inflation down.
That said, with the rapid policy adjustment put in place this year, the resulting tightening of financial conditions, and emerging signs of a slowing economy, the risks are likely to balance out somewhat. little. But policymakers will need to continue to focus on incoming data and what it says about the outlook, the risks to the outlook and the effects of monetary policy as they judge the appropriate degree of tightening.
Policy calibration complications contribute to the Fed’s communication challenge. For most of the past 15 years, the Fed has provided a considerable amount of information about the policy outlook. This guidance was helpful because for much of the period the fed funds rate was at or near its effective lower bound, and the Fed could use forward guidance on future decisions to ease financial conditions and thereby support the growth. However, with interest rates now far from their bottom and given the very great uncertainties about the outlook for the economy, the Fed will soon be unable to provide meaningful guidance on future rate decisions. Since investors have become accustomed to receiving strong guidance from the Fed to anchor their expectations about the future path of rates, this lack of communication could lead to market uncertainty, increased asset price volatility, reduction in liquidity and a widening of risk spreads. These effects may be reinforced by market stress related to the Fed’s ongoing balance sheet normalization program, under which markets may need to absorb up to $95 billion of Treasury mortgage-backed securities and agencies each month.
As always, it will be important for the Fed to communicate as clearly as possible on the outlook for the economy and politics. However, the Fed cannot communicate what it does not know. Investors will have to adjust to an environment in which they cannot depend on the Fed for clear guidance on the future direction of policy. Instead, they will have to make their own assessments of the outlook for the economy and monetary policy and invest accordingly.
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