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The Fed, the future, and flexibility
The Fed has to figure out how to assert flexibility without sounding so scary
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.
Well, that was quite the FOMC week.
Stocks jumped when Wednesday’s FOMC statement was released at 2:00; by 3:00, 30 minutes into Powell’s press conference, markets had turned around completely. The S&P 500 fell 100 points during his conference, but wound up posting a gain for the week.
The FOMC’s latest statement and related balance sheet guidance document were both reasonable, I thought. Going into this meeting, I felt that markets were overpricing the risk of a serious Fed policy error, and my initial reaction to the statement was that the Fed was calm: ready to begin hiking, but not erratically or in a volatile way. They weren’t running scared, and they weren’t trying to scare markets.
It became much harder to see it that way during the press conference. Powell began alright, but began giving seemingly inexplicable answers as the conference went on. Most strikingly, he declined to rule out rate hikes at every meeting this year and also declined to rule out a 50 basis point hike at the next meeting in March.
If the Fed were to do both of those two things, the fed funds rate would end 2022 at 2%. Yet just last month, only three out of eighteen top Fed officials called for rates to be above 2% in 2023; the vast majority saw appropriate the policy rate rising that high only in 2024. Only two called for the fed funds rate to rise to 1% in 2022. Even the consensus guess for the “long run” fed funds rate came in at only 2.5%. Thus it should have been pretty easy for Powell to all but rule out hiking at every meeting and a 50bp move in March, or at least downplay the odds. So why didn’t he? What’s going on?
After two years locked in at zero, the Fed wants to preserve optionality, but it is having a hard time doing so without sounding scary and muddling communication. They are struggling to assert that their decision making will be data-driven, rather than preordained, without that sounding like a tacit openness to rapidly tightening policy. That is, of course, a problem. In this post, I’ll discuss how to interpret that rocky Fed day, and what to expect going forward.
Nimble, humble, different, flexible
These were high-frequency words in Powell’s presser, and fairly so.
As I think is now well-accepted, the Fed took a real long time to adjust its inflation outlook to reality—and I say this as someone who still remains confident that inflation will largely come down on its own. Powell’s conferences from this time a year ago highlighted base effects, reopening, and vaccinations for a relatively speedy one-off bump in the price level. When supply chain issues really began causing disruptions in spring 2021, they were largely anticipated to ease with further vaccination and re-employment progress. A year later, base effects are long-gone, reopening turned out to not be so straightforward and linear, and the pandemic continues to affect critical parts of the supply chain.
I don’t think Powell (or anyone else) was naive to hold these expectations—variants were largely an unanticipated challenge and the future of the pandemic after vaccines was uncertain—but these assumptions led to overly sanguine inflation forecasts. This became clear by fall 2021. I don’t think “team persistent” has been vindicated, as price increases are still largely driven by the pandemic or by its effects (which too shall pass), but by the end of last year it was very clear that the Fed had forecast inflation way below reality.
So a dose of humility is recommended, and thus the Fed is preparing to be more nimble—ready to adjust policy relatively quickly in response to data. There has already been a pivot in Powell’s commentary on inflation, which occurred toward the end of October of last year. Of course, Powell represents the committee he chairs, not dictates, and is thus balancing speaking for the committee and speaking for himself. I have no doubt that the more hawkish FOMC members—three of which are on the FOMC this year—were beginning to become restless as inflation continued to rise heading into the winter, and that Powell had to pivot in order to keep everyone on board. That said, Powell has started to sound more concerned even when speaking for himself, as in his congressional testimony.
The conditions for liftoff from zero were more or less that inflation must have ran above 2% for some time, be forecasted to continue to rise above 2% for some time, and to have reached maximum employment. We are undoubtedly there on the first two counts, and more or less there on the third in the eyes of the Fed. The Fed is willing to move in March simply because it feels confident liftoff conditions will be met by then. Okay, I disagree about having reached maximum employment, but I guess that’s fair enough. But why all the hawkish talk about the future all of a sudden?
I think the point is to preserve flexibility, not to sound hawkish. The Fed does not want to lock itself into a predetermined policy path; they want to preserve optionality. Powell is pushing for data-driven policy decisions that respond to changes in the economic atmosphere. To commit to following or not following a certain path is to commit to not making data-driven policy decisions. Unfortunately, that comes off hawkish.
One cannot say “we will not do a 50bp hike in March under any conditions” and then say “we will make a data-driven policy decision in March”. What if, for whatever absurd reason, the data show a rapid increase in monthly inflation in January followed by an exponential increase in February. Whatever the reason is, suppose it doesn’t appear to be going anywhere. Would the Fed really not even at least consider a 50bp hike in such a circumstance?
The refusal to commit to anything is to emphasize the flexibility and data-driven nature of the tightening process. It’s supposed to be equal parts, “if we’re seeing inflation come in way too hot, we’ll try to kill it” and “if we see weak growth or very low inflation, we’ll chill”. I think communicating that is difficult, particularly in the current state of inflation unease while we’re still in recovery mode. And I still don’t really understand why the probability couldn’t be downplayed due to current and expected future conditions—“if the economy evolves broadly as expected”—but I think the Fed’s new framework comes with a learning curve.
But policy mistakes matter, though. Not accurately portraying the Fed’s intentions hurts the Fed, and scary talk scares markets. The Fed can very easily get in its own way.
“If you don’t know where you’re going…
…you’ll end up somewhere else.” What is one to make of all this? Where is the Fed going?
A 25bp move in March is all but guaranteed, but a 50bp move is really unlikely. There is little reason for the Fed to suddenly panic and burn down the house. Their own index of common inflation expectations, followed closely by many on the FOMC, showed little change in longer-run inflation expectations when it was quietly updated on Friday: 2.06% to 2.07% (or constant at 2.81% when centering on the Michigan surveys, just higher than the pre-pandemic average). TIPS breakevens reveal markets expect slightly higher inflation in the medium-to-long run than they expected over the last decade. “Cleaner” measures of inflation, such as my beloved trimmed-mean PCE, still show inflation at lower and manageable levels. This is what the FOMC wanted!
Friday’s Personal Income release also revealed both nominal and real consumption slowing in December, corroborating the earlier-reported decline in retail sales that month. A 50bp move would also be a dramatic one that hasn’t been done in decades. Finally, the Fed would be unlikely to do something they really aren’t expected to do. It’s one thing to not raise rates when markets expect you to (though still not a good thing) as the UK and now Canada have done, but to tighten twice as much as markets expect you to would be a serious mistake.
Fed funds futures markets currently imply a 12.4% probability of a 50bp hike; I really think the Fed would only proceed with that option if it communicates enough to push those odds up. Remember how we all knew the Fed would taper in November and speed up in December? And how now we know they’ll hike in March? The Fed would really have to make the case for why this would be necessary. What are they fighting? Who are they trying to scare?
The future is unwritten
The future path of policy is also unlikely to one of super rapid hikes. Some of the forecasts from Wall Street are honestly embarrassing—11 hikes by the end of 2023?!? Come on.
So much depends on the future path of inflation. I hate putting forecasts out there, but I am relatively confident CPI inflation will peak just slightly above 7% in January and February, maybe even March, and come back below 6% by early summer. If this is the way things go, there is little reason to continue moving rapidly to kill off inflation.
A follow-up hike in May after an initial hike in March is probably unlikely, unless the data suggests one is appropriate. Due to the odd timing of that meeting, very little additional data will be available other than another CPI and employment reading and Q1 2022’s ECI release, each likely to be benign. Waiting until June allows for more data to come in and for the FOMC to establish an “every-other-meeting” pattern that would lead to four rate hikes in 2022. Remember, only two participants saw four hikes as appropriate in 2022 just last December. I expect to see many more dots up there in March’s SEP, but there will still be a long way to go to get to five or more.
More likely than a May hike would be back-to-back rate hikes toward the end of the year, perhaps in September, November, and December. The employment situation is likely to be looking pretty good by then, and the FOMC may see more room to lean against inflation without sacrificing employment progress, particularly if inflation is lingering a good bit above whatever March’s SEP forecast for 2022 inflation is. The Fed let itself be wrong in 2022 so as not to get in the way of the recovery; the game will be very different once we are no longer recovering.
The key thing to remember going forward is that nothing is set in stone. The Fed really seems to want to make data-driven decisions. To do so requires flexibility and a refusal to commit to any possible policy path, even unlikely ones. The reality is that that’s scary—but the future is unwritten. We are in truly uncertain and unique times, and the Fed feels that it needs to have the freedom to keep from locking itself into policy decisions in advance so that it can make optimal policy choices down the line. That’s a good thing, and I hope they use that freedom wisely.
At the moment, the struggle to communicate the goal of commitment-free policy guidance is already hurting financial markets and conditions. But there need not be a dichotomy between avoiding commitment and aiming for a strong economy; “data-driven decisions” and “we will kill inflation by any means necessary” aren’t really natural synonyms. The Fed just has to figure out a way to very clearly get that across—Powell couldn’t quite get it done on Wednesday.