Fed

The US Federal Reserve has a full agenda as it engages in battle with rising inflation. Jane Monahan reports.

After responding to the shock of the pandemic, the US Federal Reserve is once again being tested. Challenges and pressures are mounting now that the Fed has started raising interest rates and inflation has soared to its highest rate in 40 years, reaching 6.4% in February, according to the US Department of Commerce. Can the Fed curb inflation without tipping the US economy into recession? The challenge for the central bank is whether it can engineer a soft landing for the US, where inflation is reduced, employment remains steady and growth slows but does not turn negative.

Jerome Powell, the Federal Reserve chair, appears confident. At the Fed’s monetary policy meeting on March 16, it raised its benchmark short-term rate by the customary quarter percentage point, to a range of between 0.25% and 0.5%, and signalled six more rate increases this year, the most aggressive pace of monetary tightening since 2008. Following the meeting, Mr Powell said to reporters: “The probability of a recession in the next year is not particularly elevated. And why do I say this? Aggregate demand is currently strong and most forecasters expect it to remain so ... The labour market, also very strong … Household and business balance sheets are strong. And so, all the signs are that this is a strong economy – indeed, one that will be able to … withstand …. less accommodative monetary policy.”

Also favouring a soft landing are the Federal Reserve’s 12 regional bank presidents, and 800 PhD-level economists and research resources. Pivoting towards monetary tightening, dealing with an overheated economy and labour market, with inflation levels high, corresponds to the Fed’s core mandate to maintain price stability – its most traditional and familiar business.

“I have a lot of respect for the adjustments and policy stance that Fed officials have already made, and confidence that they will continue on the right track,” says David Wilcox, a leading economist at the Peterson Institute for International Economics, former director of the Fed’s domestic economics division and senior adviser to the past three Fed chairs.

Managing expectations

Meanwhile, the latest US Department of Labor data is seen by many to be good news for the Fed. Currently there are higher demands for workers than people seeking jobs. The US labour market participation rate rose to 62.4% in March; and in February and March, wage increases softened, which could reduce employers’ incentive to raise prices to offset higher salaries and so slow inflation over time, economists say.

The risk of inflation expectations becoming entrenched remains, however. This occurs when businesses and workers all start to think that inflation will not be brought under control, leading to anticipatory price increases by employers and rising demands by workers for higher wages. Economists and other experts, at the time of writing, did not think the US economy had reached this point yet. But they agree that the risks of a classic wage-price inflationary spiral happening in the US are high.

Fed officials do not minimise the difficulties that lie ahead. The environment in which the Fed’s pivoting is taking place is strewn with uncertainties and conflicting cross-currents that are exacerbating supply-and-demand imbalances, and helping to keep inflation high. They include continuing fallout from the global pandemic, with renewed lockdowns and cases of the virus in China. As many of the Covid-19 supply-side disruptions have started to ease, the war in Ukraine – and the West’s sanctions against Russia – have caused another supply-chain shock. A global inflationary spike in the prices of oil, other energy products and a range of commodities such as corn, wheat, aluminium and copper have also caused impacts.

The impacts of the war and the sanctions are particularly vexing, says David Wessel, the Brookings director of the Hutchins Center on Fiscal and Monetary Policy. “On the one hand, it is pushing up inflation. There is no doubt about that, and it threatens to push up inflation expectations. But, on the other, it will slow demand. People will be spending money on gas and heating, and they won’t be spending it on other things. So that will serve to cool the economy, which is what the Fed is trying to do,” he explains.

A late call?

But what preceded the Fed’s mid-March rate hike and prospect of several more, and what are the risks that the policy tightening may trigger a recession?

One greatly discussed consideration is that the Fed pivoted late. “Hindsight says we should have moved earlier … But there really is no precedent for this,” Mr Powell said in testimony to Congress early in March.

The Fed was far from being alone in misjudging inflation in 2021. Throughout the spring and summer of that year, many economists in the private sector and other forecasters believed that underlying inflation had remained in the same 2% annual Fed target range, just as it had since the 2008 financial crisis, and they expected inflation to decline as Covid supply-side bottlenecks improved.

The Fed also underestimated the strength of consumer demand following the $1.9tn in fiscal stimulus passed by Congress early last year, as many people had high accumulated savings and increases in wealth. Indeed, according to a Morgan Stanley investor statement, Morgan Stanley economists reckoned that while the rise in energy prices could deliver a $200bn blow to US consumption this year, or an average of $1600 per household, estimated US household surplus savings are in the region of $2tn.

Priya Misra, global head of rates strategy at TD Securities in New York, adds: “I think the original sin was not really understanding how tight the labour market was.” But, she continues, “I actually am very sympathetic to the Fed not realising this. Once it did, it did move. But then again, when it might have hiked, it couldn’t.”

This was because the central bank was committed to first winding down purchases of public and private securities under its long-running quantitative easing (QE) or monthly monetary stimulus programme. Then it had to taper QE and provide forward guidance to hike. So, it was about a six-month process, from the realisation that inflation was not temporary, but instead much broader and more persistent, Ms Misra says.

There is also a risk that pressure may be put on the Fed to lift rates to levels that will trigger a recession. Charles Calomiris, financial policy expert at think-tank the Manhattan Institute, says that he thought it was “ridiculous” when the Fed only raised rates by a quarter percentage point in mid-March. With inflation running well above the Fed’s objective, and the Fed starting with real interest rates – nominal rates adjusted for inflation – that are much lower (in fact clearly negative) to get inflation down to the 2% target, higher rates will be necessary, which increases the risk of an eventual recession, he reasons.

Meanwhile the initial doubts of economists and financial policy experts that the Fed might not be hawkish enough in curbing inflation have now disappeared. Since the Fed’s March 16 announcement, many officials have indicated that they could support raising rates by half a percentage point, instead of the usual quarter point, at their next monetary committee meeting in May.

“If we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting, or meetings, we will do so. And if we determine that we need to tighten beyond common measures of neutral and into a more restrictive stance, we will do that as well,” said Mr Powell at a March 21 Washington business conference.

The neutral rate, neither positive nor negative for growth, is thought to be about 2.5%.

Fighting uncertainty

The Fed has also said that it will begin drawing down its estimated $9tn bond portfolio, as part of its tightening policy, primarily by not reinvesting in the QE holdings it has built up, letting them run off as the assets expire. The plan is expected to be ready by the Fed’s May 3 and 4 monetary meeting and implemented shortly after. Additionally, Mr Powell has said by the end of the year the run-off will be equivalent to about a one-quarter point rate hike, or an estimated $500bn in shrinkage from the money supply. Fed officials have also said they plan to reduce the holdings in a predetermined way and “in the background”, meaning that the Fed hopes the plan will proceed without the usual signalling and with the focus of markets staying on the short-term rates rises.

Ms Misra says what is being “sacrificed” in the Fed’s tightening plan is its usual forward guidance to markets about future moves. Also, to try and tell the markets that the Fed will not make a policy mistake, Fed officials keep emphasising that they will be nimble, she says, “which means they might hike more than what the market expects, they might hike less than what the market expects. They will hike based on the economic data at the time.

I think volatility is going to be higher because they are not committing to a path. They want to keep all their options on the table

Priya Misra

“So, I think volatility is going to be higher because they are not committing to a path. They want to keep all their options on the table,” Ms Misra concludes.

This is a problem, Mr Wessel believes, because markets like certainty. “But the fact is the Fed cannot convey more certainty than it has. And we really don’t know what’s going to happen with the virus, with the energy crisis, with Ukraine.”

Joe Brusuelas, chief economist at global middle market advisory specialist RSM US, says: “Given the geopolitical, economic and financial cross-currents, the probability of the Fed threading the needle and bringing the economy in for a soft landing is quite low.”

Citigroup economist Veronica Clark, in a prepared statement, said that because of the Ukraine war, there is a risk that “the Fed will have to act even more forcefully to damp inflation”. 

Personnel issues

Meanwhile the US central bank has faced other challenges recently. These include some negative publicity following the so-called Federal Reserve trading scandal, which saw the resignation of two regional bank presidents and the Fed’s outgoing vice-chair stepping down early. The three were implicated in personal investment activities which raised questions of ethical propriety, after undertaking significant trades in stocks and other assets during 2020. The trades happened at a time when the Fed was engaged in, or about to engage in, a major campaign of asset-purchasing, raising concerns about a conflict of interest. The Fed has since introduced new rules restricting the investment activities of policy-makers and senior staff.

A further challenge is that the Fed still lacks a vice-chair for supervision, the government’s most powerful bank regulator. This is an important vacancy. The Fed’s board can fill in doing routine stress-testing of banks and reviews of bank mergers. But there is no one who is making the banking system their primary responsibility.

Third, mounting pressure on the Fed to address issues beyond its monetary stability mandate, such as climate change and inequality, could potentially strain its valuable credibility as an independent economic actor.

An example of this challenge occurred when US president Joe Biden’s nominee for the post of Fed vice-chair for supervision, Sarah Bloom Raskin, a former Fed and top US Treasury official, was forced to withdraw from consideration after a Senate confirmation fight. Republican senators threatened to boycott all five of Mr Biden’s Fed board nominees over her nomination.

During the confirmation process, a key question was how far the Fed should go on climate change. If the Fed is asked to buy corporate bonds during a crisis, should it buy the bonds of all businesses, which it did, along with the US Treasury, in 2020 at the start of the pandemic? Ms Raskin reportedly said in 2020, the US should design backstops that exclude lending to very indebted fossil fuel companies. That is a recommendation to which Republicans from energy-producing states, and a key Democrat from coal-producing West Virginia, aggressively objected, depriving Ms Raskin of the votes she needed for confirmation in the evenly split Senate.

Mr Wessel’s view is that if the Fed takes up the fight of climate change when members of the US Congress do not, then there is a risk of the central bank being perceived as another political institution.

Meanwhile, after Ms Raskin’s withdrawal, Republican senators called off their boycott and the path to confirmation for four other Biden nominees for the Fed board looks more secure. They include Mr Powell, a Republican, who looks set to remain for a second term as Federal Reserve chair, the promotion of Lael Brainard, a Democrat, to Fed vice-chair and the appointment of two African-American economists, Lisa DeNell Cook and Philip Jefferson, who are expected to add diversity and a variety of perspectives to the board on policy issues at a critical economic time. Ms Cook’s position remains more uncertain after Republicans on the Senate Banking Committee refused to endorse her nomination. A Senate confirmation vote looked imminent at the time of press. 

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