Inflation has come up to a 40-year high and that should tell us several things. One is that you have to be over 60 years old to have experience with the Fed fighting inflation like this in your Wall Street career. Most of the people who are holding forth as analysts in this situation have nowhere near that kind of experience and perspective.
“ The Fed now has anti-inflation religion. ”
I’m not prepared to argue that you need to have lived through some of these Fed tightening episodes to understand them. But I am arguing that what we have seen in recent economic cycles was really nothing like what we saw in previous cycles when the Fed had to stop inflation and push it back down.
The wrong kind of experience
Most of the experience most Wall Streeters have is the wrong kind of experience to understand this.
In fact, the Fed itself is largely without seasoned experts in doing this. And the Fed already seems to have made some big mistakes in policy by adopting a policy mandate that did not focus on inflation and instead focused on full employment and ignored past simple central-banking lessons.
Previously the Fed ran a policy that relied on its outlook and didn’t bother to look to see what incoming data looked like; they called it a “bygones policy.”
More recently, it allowed itself to be muscled by the agenda of progressives in Washington to keep policy easy and to broaden its policy objective to consider things like climate change.
But the Fed now has anti-inflation religion. And in the recent minutes of its meeting, the Fed talks about getting the fed funds rate up to its long-term neutral rate and then assessing where the economy is before deciding its next steps.
On paper that sounds like a substantial move on the part of the Fed. However, the Fed’s long-run federal funds target is one that the Fed establishes during a period when inflation is stable. As a benchmark for a policy pause, however, it will leave the federal funds rate well below the current inflation rate. Historically, to bring inflation down, the Fed has gotten the federal funds rate above the prevailing inflation rate.
Fed has an firm objective, but not a real plan
We have no sense that the Fed is planning to do that anytime soon—if at all. Right now the Fed has more of a real commitment than a real plan.
While we have some guidance on Fed policy from what we call the dots or the path for the federal funds rate and we have some projections for inflation and for GDP growth as well as the unemployment rate ahead, these pieces of data only give us a scattershot view of what the Fed really thinks.
People and markets seem to think that because the economy is already weakening and because there are signs that commodity prices have weakened that the Federal Reserve is not going to continue to raise rates the way it talks about in its dot presentation.
However, I caution against thinking that way.
The mistakes of the 60s and 70s
Chairman Jerome Powell has been clear that the most important job for the Fed now is to get inflation under control and to keep inflation expectations from deteriorating. Having started to move somewhat aggressively on the interest-rate front, even after a late start, the Fed seems to recognize the risks and seems to have set a clear objective, if not a clear policy, to achieve it.
Looking back historically, the mistakes that the Fed made in the late 1960s and in the 1970s came, not from failing to raise rates, but from failing to raise rates high enough and failing to keep them high enough long enough.
It’s quite clear that the Fed will need to raise rates more in order to cause inflation to fall by enough. And the Fed is aware that this kind of tightening is going to weaken the economy and could cause recession. But the Fed’s focus is on stopping inflation and bringing it down into its target.
Market views that see the Fed backtracking early because commodity prices peaked are out of touch with real Fed policy. If the Fed were to stop its tightening too early, the progress on the inflation front would go away and likely reverse.
In the case of oil
prices are said to be weak because of some expectation that there could be a recession. If the Fed allows weakening oil prices to stop it from raising rates, then there will be no recession and oil prices will stop weakening; they will go back to rising. The Fed would have to chase after oil prices again by raising rates again until it does it correctly.
The idea that the Fed is going to let some second-order effect from its policy keep it from achieving its primary objective completely misses the point.
It’s still true that the Fed is not sure how much of current inflation is temporary and will unwind by itself and how much of it the Fed is going to have to battle to reduce. But it is clear that whatever that split, the Fed is going to fight that battle and that it intends to win.
The Fed has completely changed its tune and has gone back to its old method of talking about policy, ‘that it does the most it can for full employment when it keeps inflation under control and within its target.’ While the Fed has not rescinded the new full-employment policy objective given primacy in 2020, it seems clear that the Fed no longer is focused on creating full employment as a first priority, and, instead, is fully focused on restoring price stability.
I hope this means we have our central bank back on the job.
Robert Brusca is chief economist of FAO Economics and a longtime Fed watcher.