Credibility goes both ways

The Fed needs credibility not just as an inflation fighter but as a recession-fighter, too

Note: any and all opinions are entirely my own and do not necessarily reflect those of the Cleveland Fed, the FOMC, or any other person or entity within the Federal Reserve System. I am speaking exclusively for myself in this post (as well as in all other posts, comments, and other related materials). No content whatsoever should be seen to represent the views of the Federal Reserve System.

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Last week, St. Louis Fed president Jim Bullard (a voting member on the 2022 FOMC) said that the Fed’s credibility on inflation “is more at risk today than it’s been at any point” in the last three decades. That’s an absurd statement in and of itself—who, besides weirdos on Twitter, is really that doubtful that the Fed will “fix” inflation?—but I think it makes for a good opportunity to point out that there’s more to the Fed’s credibility than inflation credibility.

Indeed, the Fed has a dual mandate, and it would be quite ideal for the Fed to have credibility on both fronts; in fact, it would make the Fed’s job easier! The Fed is supposed to keep inflation low and stable while also aiming for maximum employment. I think it goes without saying that the Fed has credibly committed to avoiding high inflation. Whether you look at the Survey of Professional Forecasters long-term inflation expectations or market-based inflation breakevens, nobody is expecting inflation to get out of hand.

Unfortunately, the Fed is historically less credible as a low-inflation fighting central bank, and similarly less credible as an employment-maximizing institution. In my view, this is a bigger and more significant problem than any current “challenge” to the Fed’s inflation-fighting credibility. The Fed is capable of bringing an overheating economy to a standstill if it really wants to, and it definitely knows how to do such a thing. But in recent years, the Fed has proven less willing to fight low inflation and more willing to accept subpar estimates of maximum employment as good enough. The result is a Fed that runs an economy less-hot than it could, and a Fed that earns a reputation as a recession-enabling institution—not good!

In this relatively shorter post, I’ll go through exactly why that’s not good.

Why does anti-recession credibility matter?

I’m no big fan of blanket statements about credibility. Expectations can matter, but we’ve got to be really careful about who’s expectations matter, and how and when they matter. On inflation expectations, see this excellent Employ America piece that I must’ve linked on this blog dozens of times by this point. If the Fed is to control behavior by setting expectations, it’s not generally going to be the expectations of folks like you and I that matter. Inflation expectations from financial institutions likely have the most “importance”, since they factor into investment profitability and that sort of thing, but even then we must be careful.

Recession-fighting credibility is a bit of a different story, though. I’ve lumped fighting low inflation and lower employment together as these are often traits of a recession, or at least an economic slowdown. Recession-fighting credibility means that financial markets, and perhaps even the public at large, expects the Fed to come out swinging in response to a recession, or even before a potential recession begins.

Looking back at the hectic, market-breaking days of March 2020 can help illuminate how credibility works. To be sure, the fix wasn’t even close to being all from the Fed. Congress should similarly aim to convince the public that they will step up to the plate to fight a looming or present recession (even better, more automatic stabilizers should be put into place so that it’s not even a choice). But the Fed’s fast and strong actions had immediate impacts on several markets. They almost changed the financial outlook entirely—things went from extreme doom and gloom to just a little bit of doom and gloom but with sunshine at the horizon. The S&P 500 is shown below—the market collapse stopped as soon as the Fed and Congress appeared committed to stabilizing the economy (shown as the dashed line, when rates were cut to zero and the CARES Act was passed).

Consider the disconnect that many felt (and some still do feel) between stock market performance and underlying economic reality, for example. I think a lot of that is overstated—the economy is doing pretty well!—but this claim had more merit back in the summer of 2020. One factor: the Fed convinced financial markets it was serious about returning to pre-pandemic levels of employment, and therefore output, and that it would keep interest rates low for a good while in order to do so. Asset purchases were of indefinite duration; only at the end of 2020 were exit conditions provided. This really convinced financial markets rates would be low for a good while, and that policy would remain accommodative for a while. Fiscal policy helped a lot, too.

Risk-free rates, discount rates, risk premiums, and borrowing costs therefore all fell, expectations for the future improved, and there was a general understanding that the Fed would guide the economy back to where it should’ve been, no matter the mechanism you see monetary policy working by. This boosted asset prices across the board from homes to stocks, eased financial conditions, and promoted job- and income-creating business investment. Again, this wasn’t all the Fed’s doing, but the Fed undoubtedly played a big role.

The Great Recession and The Subpar Recovery

The recovery from the Great Recession was, in nearly every possible way, the exact opposite of this. The Fed got in its own way at seemingly every single possible point, beginning with the possibly fateful decision not to cut rates in August 2007.

Instead, markets were expecting rate hikes around every corner. Financial conditions did not ease even with rates at zero and ongoing asset purchases. Not until August 2011 were market participants convinced that there was no way the Fed would raise rates in the coming months. Indeed, the Fed hadn’t even explicitly told anyone that it wouldn’t raise rates until a certain point until then!

It was implicitly understood that the Fed was willing to stand by as low inflation reading after low inflation reading came in, and as job growth chugged along at generally “eh” rates for much of the last decade. The Fed decided, officially or not, that it would not risk incurring above-target inflation as a result of their own policy. True, they tolerated the transitory 2011 inflation wave, but that inflation wasn’t really their own doing. The Fed was conservative and reluctant to push too hard.

This didn’t end even by late 2015, when the Fed finally took rates above zero. The economy still had plenty of room left to go toward maximum employment, something that is now indisputable considering the continued jobs gains and lack of price pressure that followed those rate hates.

The Fed set low standards for itself with regard to what price stability and maximum employment mean. They accepted a level of maximum employment that was exceeded by millions without inflationary pressure, and indeed a level of employment that barely hit 2% inflation in a good month. Markets expected the Fed to be okay with underachievements, and these expectations adjusted financial conditions accordingly.

Lessons learned?

The Fed cares, if don’t nobody else care

Instead, the Fed could have worked harder to better-communicate its goals, and to more credibly commit to them. I argued in a previous post that if the Fed could clearly and credibly communicate its commitment to achieving maximum employment, financial markets would price themselves accordingly. The yield curve would fall to near-zero until the point where maximum employment was expected to be reached. The guarantee of low interest rates until that point would bump up asset prices and ease financial conditions, thus encouraging investment and job creation. Those new jobs would provide new incomes that contribute toward the inflation target.

We can only wonder how the recovery from the Great Recession may have been different had the Fed credibly committed to avoiding low inflation and low employment. Increased investment might’ve created more jobs more quickly; these new incomes might have put more upward pressure on prices, avoiding the realized decade of low inflation. But it looks like, for 2020 and 2021 at least, the Fed avoided many of those mistakes. Its credibility as a recession-fighting institution has been sharply improved.

However, the Fed should not give up in the fourth quarter. We are closing in on pre-pandemic levels of employment rapidly. Yes, inflation is running way above target, as we all know. Whether you’re team transitory or whatever, there isn’t really any evidence that the Fed’s credibility in fighting high inflation has been diminished, at least in the eyes of those who matter. Most price setters aren’t watching the Fed, anyway.

The Fed’s forward guidance for over a year now has been that it will not raise rates until it sees maximum employment and inflation above 2%. The second part is, of course, fulfilled. But by raising rates, the Fed will define how it sees maximum employment and therefore the process of recession recovery, more broadly. At this point, the Fed’s concern is clearly much more about inflation than jobs, which is fair enough. The Fed should be clear, though—is this maximum employment? By raising rates, they must either see it as such or decide they don’t care. The Fed must justify rate hikes. The Fed should be triumphant, not making a defeated move of retreat. Inflation is high, yes, but the Fed cannot become tunnel-visioned about it.

March now seems like the assumed liftoff point. If that is the Fed’s intent, it is time to start really communicating that. They should not let themselves catch markets by surprise. Flexibility going forward should be emphasized; they should not rush into several rate hikes too soon and too quickly, nor should they commit to a too-rapid tightening cycle. Paced rate hikes with proper communication won’t get too far in the way of labor market progress, but unexpected or unanticipated moves increase risk and can tighten financial conditions. Clearly communicating balance sheet policy (runoff and quantitative tightening) is important, too.

The Fed did a lot to boost its credibility as a recession fighting central bank this time around. It tolerated high inflation and seemed very committed to bringing employment down faster and more inclusively than before. This bodes well for future recessions, as markets will be more willing to trust the Fed to do the right thing. But the Fed still has to show that it can get the exit strategy right. They must justify and defend maximum employment while balancing the inflation side of the dual mandate—it’s an unenviable task, but one that must be done. It’ll only make the Fed’s life easier in the future.