The Fed Is Moving More Slowly Than the Recovery

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The Federal Reserve has lately come under increasing pressure to shift its thinking on inflation and monetary policy. A course correction was indeed overdue. At this week’s meeting of its policy-making committee, the Fed budged — but not quite enough.

The central bank held interest rates at zero and announced no plans to taper its $120 billion-a-month bond-buying program. But its closely watched “dot plot” showed a majority of its officials now projecting at least one rise in interest rates in 2023. A growing minority — seven of the 18, up from four in March — say they now expect an increase next year to be appropriate. Financial markets took note, and yields moved up a notch.

This confirms, at least, that the Fed is watching developments. Nonetheless, there’s still something of a disconnect between what’s happening in the economy and what the Fed is saying.

In communicating its thinking, the central bank’s dilemma is real. It saw no choice last year but to bind itself indefinitely to a short-term interest rate of zero and an extended program of asset purchases. The pandemic had hammered the economy and fiscal policy was responding sluggishly. An open-ended promise of monetary accommodation seemed the only way to support demand. Part of the formula was to promise not to get ahead of economic developments. Rather than trying to look forward, as central banks have traditionally done, the Fed would wait for “maximum employment” and an unspecified period of above-target inflation before considering tighter policy.

Whether or not this stance was in fact necessary, rapidly changing conditions have required an adjustment. The economy is growing faster than the Fed expected three months ago, and inflation is running hotter. Consumer prices rose 5% in the year to May, the fastest rate since 2008. Granted, the pandemic pushed prices down last spring, so part of that excess will be temporary, but there are signs that underlying inflation is picking up.

The Fed’s other declared criterion for a shift of policy — maximum employment — is also problematic. Total employment is still well below pre-pandemic levels, suggesting plenty of slack to take up. But many businesses say it’s hard to fill vacancies and wages are rising, suggesting a labor market that’s tight, not loose. As with prices, pandemic-induced distortions muddy the picture. When the emergency supplements to unemployment benefits expire, more people are likely to start looking for work. On the other hand, the post-pandemic labor market might demand different skills, and some workers could opt for early retirement over returning to the office or factory.

These complications make the Fed’s job much harder than usual. But its public analysis still tends to dismiss signs of excess demand too readily as short-lived developments rather than cause for concern. It should recognize the risk that that a massive fiscal boost (far more than expected last year), a prolonged period of maximum monetary stimulus, an all-but-unprecedented release of post-pandemic private spending, and continuing supply-side frictions will push inflation more than “moderately” above its 2% target for long enough to shift expectations and get entrenched. That would give the Fed a much bigger problem than it has now.

Privately, no doubt, the Fed’s board members understand all this and are attuned to the risk. But their public communications need to lean more in this direction, before expected inflation trends higher. The central bank should dial back its official resolve to do nothing until its goals have been reached (whatever that means). Instead, it should emphasize open-minded attention to incoming signals and a renewed willingness to look ahead.

Editorials are written by the Bloomberg Opinion editorial board.

©2021 Bloomberg L.P.

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