Business & Investment

Rate action: The Fed needs to think creatively again

The challenge is normalization, that is, returning monetary policy to its pre-crisis settings. And the Fed doesn’t yet understand both traditional benchmark rates and non-traditional balance sheets.

The temporary inflation debate in the United States is over. The surge in US inflation has been much worse than the Federal Reserve expected. Permanently optimistic financial markets are making this a big step forward. The Federal Reserve is widely presumed to have both the wisdom and firepower to curb the underlying inflation. I don’t know yet.

As part of that, the Fed advises patience. I’m confident I’m happy to wait, as the bad predictions will eventually turn out to be correct. Not surprisingly, the Fed telegraphed such a response within the framework of the “Average Inflation Targeting” adopted in the summer of 2020. -Target inflation. I didn’t know much about what it was in.

In theory, average inflation targeting seemed to make sense. In short, it’s an elegant arithmetic consistency that balances undershoots and overshoots. In fact, it was flawed from the beginning. It is a backward approach in nature, largely conditioned by slowing growth and a long experience of low inflation. The Federal Reserve believes that the pandemic shock of early 2020, as many have done, was cut from the same cloth as the 2008-09 global financial crisis, already risking low inflation. He emphasized yet another unrealistic recovery of disinflation that could drive deflation.

Just like in Japan. Since the collapse of the dot-com bubble in 2000, federal policymakers have been worried about the end of the crisis-prone US economy like Japan. These concerns are understandable if the crisis occurs when inflation is already dangerously close to zero. However, by sticking to the risk of Japanese-style deflation, the Fed has largely ignored the potential surprise of large upward inflation.

And that’s exactly what happened. Thanks to the rebound after the explosive blockade of aggregate demand, the Fed itself has played an important role in fuel supply, and the already stressed world supply chain has collapsed rapidly. From food, semiconductors and energy to transportation, housing and wages, today’s diverse price and cost pressures are innumerable. Temporary price adjustments are widespread, and a major inflationary shock is imminent.

But there are more complicated issues. It’s the Fed’s belief in the magical power of the balance sheet. Like the average inflation target, quantitative easing has emerged from the recent crisis. Ben Bernanke, first as the Federal Reserve Board and then as chair, led the responsibility for cataloging an endless list of non-traditional policy options. Fiat As the nominal policy rate approaches zero bounds, the currency system becomes free to use.

Bernanke first expressed this in a thought-experimental perspective in 2002, emphasizing the Fed’s unlimited capacity for liquidity injection through asset purchases in case of increased deflationary risk. But as reality approached the hypothesis in 2009, Bernanke’s script became an action plan. As it happened again at the depth of the COVID-19 shock in 2020. While off the zero-bound reference point, he never ran out of creative Fed ammo.

The challenge is normalization, that is, returning monetary policy to its pre-crisis settings. And the Fed doesn’t yet understand both traditional benchmark rates and non-traditional balance sheets.

The Fed faces two complex issues in policy normalization. First, the unwinding of ultra-easy monetary policy is a delicate operation that increases the likelihood of asset market and asset-dependent real economy modifications. Second, there is confusion about the normalization time frame, the time it takes to return the policy to its pre-crisis settings. Until now, there was no urgency for normalization. Continued low and often below-target inflation will give the central bank of the inflation target ample room to gradually feel the path to normalization.

Think again. Now the Fed needs to normalize in the face of inflationary shocks. This casts doubt on the glacier process envisioned in the low-inflation normalization scenario. The Fed was unable to make this important distinction. It telegraphed the mechanical rewind of the two-step approach used in the depths of the crisis. The Fed simply sees normalization as the opposite. In other words, first review the balance sheet and then raise the policy rate.

That ordering may be appropriate in a low-inflation environment, but inflationary shocks make it infeasible. Adjusting the balance sheet, which is the desired first step, may have a limited impact on the real economy and inflation. The balance sheet transmission channel, which runs through the delay in asset effectiveness due to long-term interest rate and asset price adjustments, is at best a very detour. The Fed needs to reassess its mechanical approach to policy ordering.

With inflationary pressures ranging from temporary to widespread, the policy rate should be the first line of defense, not the last. Under actual (inflation-adjusted) conditions, the federal funds rate of -6% is now deeper in the negative territory than the mid-1970s lows (-5% in February 1975) when monetary policy failed. increase. Set the stage for big inflation. The Fed today is terribly behind.

My advice to the Federal Open Market Committee: It’s time to get ready for creative thinking. Inflation is skyrocketing, so stop defending bad forecasts and forget to tinker with your balance sheet. Start the hard work of raising interest rates before it’s too late. Independent central bankers can afford to ignore predictable political backlash. I wish the rest of us could do the same.

The author is a faculty member at Yale University Morgan Stanley Asia

Copyright: Project Syndicate, 2021

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