What was the Fed thinking?
(A quick take on today's policy inaction)
Today the Federal Open market committee (FOMC) met for the first time in 2022. They decided to stand pat with respect to policy. By that I mean they stayed the course announced at the December 15, 2021 meeting, they are sticking with the planned reduction in asset purchases and are not yet ready to raise the federal funds rate target.
Given that the CPI rate of inflation came in at an eye-popping 7.0 percent for the month of December, you might be thinking, “huh?”
That was my first reaction, in fact. I thought, “hang on, they didn’t raise the fed funds rate target today?”
Once I calmed my macroeconomic passions, I realized I shouldn’t be that surprised.
So, what was (or is) the Fed thinking?
We can try to answer that first by looking at their published statement from today, which I partly reproduce here with some emphasis added:
“The Committee seeks to achieve maximum employment and inflation at the rate of 2 percent over the longer run. In support of these goals, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent. With inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate. The Committee decided to continue to reduce the monthly pace of its net asset purchases, bringing them to an end in early March. Beginning in February, the Committee will increase its holdings of Treasury securities by at least $20 billion per month and of agency mortgage‑backed securities by at least $10 billion per month. The Federal Reserve's ongoing purchases and holdings of securities will continue to foster smooth market functioning and accommodative financial conditions, thereby supporting the flow of credit to households and businesses.”
Aside from the understatement that inflation is “well above 2 percent,” the Fed is implying they do not view the economy as “over-heating” just yet. It’s close, but not yet. They do not cite any reason why they think that—at least not in that statement—but clearly, that’s what we can surmise from that statement.
I don’t agree with that, in fact—not with what we see in the GDP, consumption and inflation numbers. But, they’re the Fed and I’m just me.
However, as I mention above, I suppose I should not be surprised for a few of reasons:
1. From the Fed’s previous policy statements at the end of last year, and the adjustment to their expected path for the Fed Funds rate published with the December 15 meeting (and seen here), it’s clear that they are going to raise rates in 2022, just not necessarily in January. In fact, in their December statement, they make no such mention of a rate hike early in 2022. The press has been speculating, of course, and you can read that speculation here. But I suppose I shouldn’t have been surprised today.
2. The second reason I shouldn’t have been surprised is found in their forecasts from December (discussed in this previous post). Let’s a look at that forecast this time focusing on the inflation estimates:
The Fed doesn’t seem to be as worried as much as everyone else about inflation—at least not enough to take stronger action here in January of 2022. In fact, they expect inflation to be below 3.0 percent by the end of 2022! And, while they did not have the December CPI numbers yet during their December 15th meeting (when these forecasts were published), surely they had a good sense of how that number would turn out. If they were worried, they could have acted on December 15th.
(Also, as noted in this post, the Fed focuses on the PCE as a measure of inflation, as shown in the table above, more so than the CPI.)
For whatever reason, it appears the Fed is not as riled up about inflation as much as everyone else. Not enough, at least, to deviate yet from their planned course of action for 2022.
3. As is also seen in the forecasts, the Fed expects real GDP to cool off from 5.5 percent in 2021—to 4.0 percent in 2022. That expectation is consistent with their inflation forecast. They expect those inflationary pressures to abate as the economy slows a little.
One thing that strikes me as odd, however, is their forecast for the unemployment rate—expected to be lower in 2022 at 3.5 percent than the 4.3 percent for 2021. That is not consistent with a slowing economy. I find that very curious.
For now, those are my thoughts on today’s policy inaction. To make more sense of the relationships between GDP, inflation, and the unemployment rate, in my next post I am going to dive into what’s called “Potential GDP.” That post, coming in a couple days, should help us understand further what the Fed is up to.
Professor, loving your blog, it brings back some good memories of your advanced macro class! Some thoughts below but it's been a while since I've been in an econ class so there are definitely some cobwebs!
1) Firstly, I think the Fed has a tendency towards the conservative. I mean that to say the idea of a surprise/out of forecast adjustment of the federal funds rate while not unprecedented, is not typically in the style of the Fed. I think the Fed Chairs tend to want to avoid a moment of "Irrational Exuberance". So since they hadn't previously mentioned an early 2022 rate hike, they may want to avoid the jolt to the market. However I don't think this is quite playing out the way they had hoped if you go look at 10 year treasuries today, or even over the last few months. If the fed is trying to play the expectations game, I'm not convinced the market is taking them seriously yet (though the 10 year rate is still <2% so even the market thinks that at least in the mid/long term the fed is going to keep inflation controlled).
2) If I look back at the last PCE release, the inflation rate excluding energy and food was "only" 4.5% year over year. If I'm remembering back to some of my Econ classes, there is some benefit to removing Energy/Food from inflation measurements in order to get a more consistent feel for inflation's actual effect (since food and energy can be more cyclical and price sensitive in nature). That could be part of why there feels like a disconnect between where the Fed is at in terms of their response and both the headline grabbing 7% number and all of our collective lived experience of what it feels like to buy something right now (Things definitely feel more expensive!)
3) As far as why the Fed would forecast a declining rate of GDP growth while forecasting a decrease in the unemployment rate could that be partly due to participation factors? There are simply still something like 3.5 Million fewer employed people than there were prior to the pandemic/recession, and the labor force participation rate doesn't seem to be improving dramatically, so the Fed may see some of that reduction in unemployment rate as caused by people choosing to leave the work force. This may also play into the rate decrease question as I think Fed Chair Powell has shown at least to some extent that he thinks the natural rate of unemployment is lower than people may think, so the Fed may view us as farther from "full employment" than the general market might.
Overall I agree it definitely feels like the Fed should have done a bit more, or read the tea leaves a bit better to realize they were undershooting the market's expectations, but I think these may be some of the reasons they didn't.