The Fed Has Played With Fire: Now Comes A Reckoning

Milton Ezrati

Chief Economist

The Federal Reserve (Fed) was always playing with fire when for years it poured liquidity into financial markets and the economy. Of course, for much of the time policymakers had little choice. First, the 2008-09 financial crisis demanded measures that would forestall a succession of bankruptcies, and that meant low interest rates and easy credit. Then, the frustratingly slow economic recovery that began in 2009 seemed to beg policymakers to continue such support. Even as they poured on the liquidity, Fed governors and presidents worried aloud over the chance that the policy would build a dangerous inflationary bias. Now, it seems the Fed’s day of reckoning has arrived.  Inflationary signs have emerged. Monetary policymakers now face a great test to regain control with monetary restraint and at the same time keep markets and the economy from suffering a reverse.

The extent to which liquidity has built up in the financial system can give a sense of what the Fed now confronts. Between 2008, when the financial crisis broke, and 2013, when those fears had largely subsided, the Fed kept interest rates near zero and provided an abundance of credit, in large part by buying bonds, what the Fed referred to as “quantitative easing.” Those bond purchases increased overall levels of liquidity in markets some 250% during this time. The country’s money supply — currency in circulation and checking accounts at financial institutions — increased some 50%. Inflation, despite its historical tendency to rise with increased levels of money and liquidity, remained quiescent. Consumer and producer prices rose at annual rates of only 1.9% in 2013.

At the time, the Fed did allude to the ultimate need for a policy change, a shift toward something less accommodating that would head off any buildup of inflationary pressure. Yet, they did little to change things. On the contrary, policy kept short-term interest rates near zero, and the quantitative easing continued apace. Because the Fed was still buying bonds, its balance sheet expanded some 25% in 2014 and the supply of money rose by a like amount. In the Fed’s defense, it still had to deal with a slow pace of economic growth. The nation’s gross domestic product (GDP) grew only 2.5% in real terms in 2014, slow by any standard but especially for a cyclical recovery. And inflation remained subdued, with consumer and producer prices still rising less than the Fed’s preferred rate of 2.0%.

Since, the Fed has moved to correct policy but only very gradually. It tapered, the pace of bond buying and began to raise short-term interest rates from zero. A lack of restraint seemed only reasonable. The economy, after all, remained weak, growing only 2.25% a year on average in 2015 and 2016. And inflation remained subdued. So the Fed took its time.  Policy took until 2015 to raise short-term interest rates to 0.5%.  After instituting a slowed pace of bond buying in 2015, purchases plateaued in 2016 and 2017.  In 2018, the Fed finally began to sell off these holdings and withdraw liquidity from the system. Even then, its bond holdings fell only 3%. The money supply, however, continued to expand robustly, no doubt as a lagged response to the still huge amount of liquidity left in the system. It has risen 30% from 2014 to the middle of 2018.

This year, however, has challenged the Fed’s decision to pursue gradualism. Economic activity has become considerably more robust. The strengthening began last year but so far this year GDP growth has accelerated to over a 4% annualized rate of expansion in the second quarter with signs of even stronger growth in the third. More significantly, huge increases in employment, averaging over 200,000 new jobs created each month, have brought the unemployment rate down to 4% of the workforce, full employment by any definition. Instead of the former weakness that once justified a very gradual approach to the adjustment of monetary policy, more recent economic strength just about demands a more concerted response from the Fed. And most ominous of all, inflation has picked up. According to the Labor Department, consumer prices have increased 3.5% over the twelve months through August, the most recent period for which data are available. Producer prices have shown a comparable rate of increase.

If the Fed wants to stay ahead of events, policy will have to change faster than it has. The higher rates of inflation, especially since low unemployment rates promise more, have changed the game for Fed policymakers. With consumer prices rising at the rates just quoted, short-term rates today still fail even to keep up. Borrowers pay back in dollars that are worth less than when the loan was made, even after including accrued interest. The same could be said of long-term rates. Ten-year treasuries, for instance, yield about 2.9%, still half a percentage point below inflation. Such comparisons surely describe an environment of easy credit. They show that the Fed, despite its gradualist adjustment efforts, remains more expansive than not.

Policymakers surely feel the urgency, or should.  They know that once an inflationary bias takes hold, it will build on itself.  And when once that starts, policy changes can only right things by shocking the system. Since those who run the Fed want to avoid the need to create such shocks, they must feel a powerful spur to adjust policy more quickly now before the inflation becomes established.  With the economy strong and employment at the full, they should have little reason to worry about a more restrained monetary policy except perhaps for concerns the market rally.

A concerted move on monetary policy now — to raise interest rates faster than previously and slow money and liquidity growth more dramatically — could conceivably reverse the market rally that has already proceeded longer and further than historical norms.  And it might, though the strong economy would offer markets support even with higher interest rates and less generous flows of liquidity.  Still, policymakers owe it to the longer-term future to take such a risk and adjust more definitely now. If they fail to do so and inflation finds a basis to build on itself, the resulting economic and market ills will be much worse.

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