The Fed’s Job Isn’t Getting Any Easier

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The Federal Reserve finds itself committed, whether it likes it or not, to a daring experiment in monetary policy.

Three months ago, with the outlook for fiscal stimulus unclear, the Fed expected the economy to grow by 4.2% this year, with inflation at 1.8%. Short-term interest rates, it promised, would be held close to zero through 2023. Yesterday the central bank took account of the enormous new stimulus that Congress recently passed, along with the progress made in rolling out vaccines and restarting the economy. It raised its growth forecast for this year to no less than 6.5% and its inflation forecast to 2.4%.

And short-term interest rates? They’ll be held close to zero through 2023.

You might think this startling change in prospects for demand and output would have prompted the Fed to adjust its plans. The problem is that it can’t act freely. Through most of last year, proposals for a second round of budget relief were interminably held up. With interest rates already at their floor, the central bank’s only way of providing the missing stimulus was to promise indefinite large-scale bond buying and interest rates held at zero until faster inflation was not just a likely prospect but a confirmed and sustained outcome.

The Fed had to tie its own hands because Congress failed to deliver fiscal stimulus when it was needed. Now, lawmakers have delivered more stimulus than the economy requires — but the Fed is stuck with its earlier commitments. Even a subtle move away from its previously declared position risks scaring investors, sending turbulence through financial markets, and calling its credibility into question.

Yesterday Fed Chairman Jerome Powell made light of this dilemma. He argues that a moderate rise in the inflation rate is to be welcomed, that the economy has enough spare capacity to contain any surge in prices, and that the central bank’s long-term commitment to anchor average inflation at 2% is not in doubt.

He’s right on the first point, at least. The inflation rate has stayed persistently below 2% for years. A rise to 2% and, for a time, a bit more than 2% would be a sign of improving economic health.

But Powell’s other points are more speculative.

He thinks that the prospect of very low unemployment doesn’t signify an unduly tight labor market and rising cost pressures. Many of the workers laid off due to Covid restrictions stopped looking for work and don’t count as “unemployed.” They’ll presumably resume searching for jobs as the economy recovers, so there may be more spare capacity than the standard measure of joblessness suggests.

This could prove right, but it’s unclear how much lasting structural change the pandemic will cause, and what skills will be in demand. The opportunities for displaced workers might be more limited — and the labor market could tighten faster — than the Fed expects.

If that happens, the credibility of the Fed’s longer-term inflation commitment will come under pressure. The Fed says it expects the inflation rate, after rising this year to 2.4% this year, will fall back to 2% next year and 2.1% in 2023. This isn’t implausible, or worrisome in itself. But it remains to be seen whether investors go along with that forecast. If private expectations of longer-term inflation rise above 2%, the Fed won’t be able to ignore them, and its policy dilemma — stick to the plan or attend to the risk of inflation — will have to be faced.

To be clear, Powell and his colleagues are doing their best under difficult circumstances. Their task would be very much easier if fiscal policy were better aligned with the economy’s need for new stimulus. The $1.9 trillion American Rescue Plan Act includes many good and necessary expenditures, but it was bigger than needed to fill the remaining demand gap, and many of its programs are poorly targeted. From too little budgetary stimulus to too much in the space of a few months: No central bank, however skillfully managed, can make up for such erratic and ill-judged fiscal policy.

Editorials are written by the Bloomberg Opinion editorial board.

©2021 Bloomberg L.P.

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