The Federal Reserve Needs to Act on Powell’s Words
(Bloomberg Opinion) -- When the U.S. Federal Reserve holds its next policy-making meeting in mid-December, officials will face a tough decision: Whether to remove stimulus by cutting back more sharply on asset purchases, as Chair Jerome Powell suggested they might in his testimony to Congress this week. I think they should and probably will double the pace of tapering, setting a trajectory to end the asset-purchase program by mid-March.
No doubt, accelerating the taper only six weeks after initiating it would be a bold move, particularly given the economic uncertainties that the new Covid variant presents. Only a few weeks ago, I would have expected the Fed to stick to the original trajectory. But now the cost-benefit analysis has evolved, for three main reasons.
First, and most importantly, the economic picture has changed, suggesting that the Fed might need to start raising interest rates sooner to keep inflation in check. Consumer prices have kept rising at a fast pace, as Powell noted in his testimony. The Fed’s preferred measure, the core price index for personal consumption expenditures, was up 4.1% in October from a year earlier, more than double the central bank’s 2% target. Private-sector wages have increased 4.6% over the past year, the fastest pace since the 1980s. According to a New York Fed survey, the median household expects inflation to average 4.2% over the next three years, up from 2.7% a year earlier and the highest reading in the survey’s history. The labor market has tightened rapidly: The number of unfilled job openings is unusually high, both in absolute terms and in relation to the number of unemployed people, and people are quitting jobs at the highest rate on record.
Second, as Powell has made clear, ending the asset-purchase program is a prerequisite for raising short-term interest rates from their current near-zero level. Raising rates while still purchasing assets makes little sense, because it would entail removing stimulus with one hand while maintaining it with the other.
Third, a display of flexibility would be good risk management. In hindsight, it’s clear that the Fed’s commitment to a highly accommodative monetary policy has boxed officials in, limiting their ability to respond quickly to rising inflation risks. By accelerating the taper, the Fed could break out of this box, putting markets on notice that it’s keeping its options open. More optionality is better when the economic outlook is particularly uncertain and inflation risks are tilted to the upside.
But what if this shift triggers a market tantrum, an outcome that Fed officials have been trying to avoid? This is certainly a risk, but it’s preferable to locking the central bank into an unduly inflexible policy path. Also, it’s probably not that big of a risk: Markets have responded calmly to officials’ statements that a taper acceleration should be on the agenda at the mid-December policy-making meeting. Investors seem to recognize that policy will depend on the evolving economic outlook, and that with Powell and Lael Brainard at the helm, the Fed will maintain a dovish bias regardless of what they do with the taper.
Another danger is that the emergence of the omicron variant could prolong and deepen the pandemic. But that doesn’t necessarily mean that the Fed will come to regret having signaled a faster removal of monetary stimulus. On the contrary, the greater uncertainty offers yet another argument in favor of showing greater flexibility.
The Fed needs to act at the December meeting. Any further delay would make it very difficult to complete the taper in time to have the option of raising interest rates at the March policy-making meeting. As a result, the central bank would be locked into the current trajectory, ruling out liftoff until June at the earliest. That would be a mistake.
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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