Previously published on March 16, 2022 in
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By Milton Ezrati, Chief Economist at Vested

Federal Reserve (Fed) policy makers have fully met market expectations. As part of their still-new counter-inflationary effort they have ended their practice of directly buying securities in financial markets, what the Fed calls “quantitative easing” and raised the benchmark federal funds rate 0.25 percentage points to 0.5%. Also in line with expectations, the policy statement indicated more rate hikes to come and very likely also efforts to absorb inflationary liquidity from the system by selling some of the huge asset portfolio amassed by the Fed during the long period of quantitative easing. For Wall Street’s and Main Street’s inflationary concerns, all this is a relief.

Perhaps the most welcome part of the Fed announcement was something few expected. The press release described today’s inflation as the result of “broader price pressures” and not the war in Ukraine. President Biden, for obvious political reasons, has blamed rising energy prices and by implication the overall inflation on Russia’s Vladimir Putin. Had the Fed gone along with that kind of reasoning, it would have left all fearing that monetary policy makers lacked the conviction needed to deal with ongoing price pressures. Especially since Fed Chairman Powell had for some time last year dismissed the inflationary with which all were suffering as “transitory,” this new, more serious characterization should give people greater confidence that the Fed will diligently work to blunt it.

For all that is encouraging in what the Fed has done and said, there is, however, also room for disappointment. Having suffered over a year of building inflationary momentum rising to almost an 8% annual rate, the worst in forty years, there is reason to see recent Fed actions as too cautious, doing too little too late. That certainly was the judgement of St. Louis President James Bullard who dissented from the Fed’s decision, pressing for a larger, 0.5% federal funds rate increase. The history of the great inflation of the 1970s and 1980s prompts many to lean in his direction and worry about a too cautious Fed. They are aware how a lack of forceful counter-inflationary moves then allowed inflation to embed itself into the economy and make it much more difficult to contain. After what has happened in the last 18 months, such a prospect now seems far from unlikely. It would seem to demand faster rate increases sooner, such as President Bullard wants, and more active efforts than the Fed has promised to reverse the effects of past quantitative easing.

No doubt monetary policy makers have balanced such concerns with worries that too sudden a move toward monetary restraint will cause markets to crash and perhaps bring on recession. Though not unreasonable, it would be easy to overstate such concerns. Markets seem to have taken the Fed’s announcement well. Indeed, they may have responded with relief that the Fed was at last taking the inflationary threat seriously. Nor does the risk of recession otherwise look serious. To be sure, the post-pandemic economic surge is slowing, but little points to outright recession or even the kinds of vulnerabilities that might give the Fed pause.

Besides, for all the drama of the Fed’s policy shift, what it is doing is far from restrictive. Consider that an 8% rate of inflation enables someone to repay borrowed funds with dollars that are worth 8% less in real terms than the year before. If people borrow short term at the federal funds rate of 0.5%, they enjoy the use of the money for a year and effectively pay the lender far less value than he earns from the interest charged. Indeed, matters are such that the lender actually pays the borrower in real terms to use the money, about 7.5% a year. In other words, a major incentive to borrow and spend remains, hardly a restrictive monetary environment.

Making the judgement that so far the Fed has done too little hardly condemns the U.S. economy to suffer an ongoing inflation on a par with what befell it in the 1970s and early 1980s. Rather, a recognition that the Fed has not done enough makes clear that before too long policy makers will have to accelerate rate increases and reverse the effects of past quantitative easing more dramatically than suggested by recent Fed statements. Circumstances will demand it. Presently, consensus expectations look for the federal funds rate to rise to just under 2% by year-end 2022 and to 2.75% by year-end 2023. If the Fed does its job, those numbers will look low in hindsight.

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