Federal Reserve Put Itself Between a Rock and a Hard Place

(Bloomberg Opinion) -- Evidence that the Federal Reserve needs to tighten monetary policy continues to accumulate. First, inflation rates continue to move higher, and are likely to stay there for longer. The consumer price index has risen by 6.2% over the past 12 months, the fastest pace in 30 years. Moreover, the upward pressures on inflation are broadening and spreading to areas that are less likely to prove transitory, such as apartment and home rental costs. It’s no longer the case of a few outliers sparking inflation.

Second, the labor market is tightening and wage inflation is accelerating. The civilian unemployment rate has fallen to 4.6% and the Job Openings and Labor Turnover Survey, or JOLTS, report released Friday shows that the number of unfilled jobs remains above 10 million and that the “quits rate” (the number of workers who are quitting their current employer to find jobs elsewhere) is at a record level. These measures of labor market tightness are supported by recent wage developments. The employment cost index for private workers’ wages and salaries has risen by 4.6% over the past four quarters, the fastest pace since the 1980s.

Third, the persistence of rising consumer prices has caused inflation expectations to climb. The New York Fed’s Survey of Consumer Expectations finds that median three-year inflation expectations have climbed to 4.2% from 2.7% a year earlier. Market measures also show significant increases, with the 10-year breakeven rate on Treasuries, or what investors expect inflation to average over the life of the securities, now at 2.7%, up from 1.7% a year ago. 

So why is the Fed not moving faster? As I see it, there are four reasons. First, central bank officials still view recent inflation pressures as due mainly to supply chain disruptions and frictions introduced by reopening of the economy and, thus, mostly transitory. 

This may turn out to be true, but also may prove to be irrelevant. If higher inflation gets into wages and pushes inflation expectations even higher, you may still have an inflation problem even after the transitory factors dissipate.

Second, Fed officials don’t think the economy has reached the maximum level of employment consistent with their 2% average inflation target. In particular, policy makers note that the participation rate for prime age workers fell sharply during the pandemic and is currently more than one percentage point below its peak during the last business expansion. As employment rises and the labor market tightens, Fed officials expect the participation rate to rise, boosting the supply of labor.

Perhaps. But counting on the participation rate to move up quickly enough to ease labor supply constraints seems pretty risky. That is because participation rates typically respond to higher employment slowly rather than quickly. It took four years, from 2015 to 2019, for the labor force participation rate for prime age workers to move up by two percentage points. When the economy is expanding rapidly, the labor market may get very tight before the participation rate responds and moves significantly. Because the pace of growth during the last expansion was modest, there was more time for the participation rate to move to augment the supply of labor. 

Third, Fed officials still view inflation expectations as well-anchored. In particular, the Fed’s Index of Common Inflation Expectations has risen very modestly and currently sits at 2.06%.

Some measures of inflation expectations are well-anchored and some aren’t. And for those that are, there are reasons for skepticism about their importance. The fact that the five-year, five-year TIPS breakeven rate hasn’t moved up much says little about the nearer term inflation outlook. All it means is that market participants expect that the Fed will eventually do its job and and push inflation back down to 2%. Similarly, the common index of inflation expectations may not be a good guide. Its history only dates back to 1999 and it has never moved much. Is this index a good one to get a timely read on inflation expectations? Or is it a lagging indicator? The jury is out.

Fourth, Fed officials believe that the tapering of asset purchases needs to be completed before they can start raising interest rates. On the current taper path, this means no monetary policy tightening is possible until June.

While it makes no sense to be purchasing assets and raising short-term rates concurrently, the Fed is responsible for this problem because it delayed the start of the taper program. It’s also a problem they could address by accelerating the tapering.

As I see it, Fed is between a rock and a hard place. On one hand, evidence continues to accumulate that the Fed is behind the curve in removing monetary policy accommodation. On the other, the Fed has locked itself in with a regime in which it won’t raise short-term rates until after the tapering of asset purchases is completed in June. 

What’s the best way out? Hope and pray that inflation subsides and the labor market loosens up? Or would it be better for Fed officials to accelerate the taper so they could begin to tighten monetary policy sooner?

Neither option is attractive. If it waits, the economy could significantly overheat, requiring the Fed to jam on the brakes, precipitating an early recession. In contrast, if the Fed were to accelerate its asset purchase taper, a “taper tantrum,” which Fed officials have spent the last year trying to avoid, would be inevitable. Not only would a faster taper be a tacit admission of a major policy error, but also market expectations about the timing of tightening would be pulled forward and its likely magnitude increased substantially. And, the Fed would have to retreat from its goal of making job opportunities more inclusive.

It's a Hobson’s choice. Most likely, it will be resolved by the Fed sitting on its hands and hoping for better news on inflation, labor market supply and inflation expectations. But as my old boss Tim Geithner was often fond of saying, “hope is not a strategy.” That, in itself, is problematic. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Bill Dudley, a Bloomberg Opinion columnist and senior adviser to Bloomberg Economics, is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.

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