Cautious Optimism at the Fed

The Federal Open Market Committee (FOMC), the policy setting arm of the Federal Reserve, is expected to upgrade members’ assessments of the economy in the statement and forecasts that it releases at the conclusion of the March meeting. The statement will affirm the FOMC’s commitment to low rates and $120 billion in asset purchases per month, while acknowledging improvement in the performance of the economy since January.

The FOMC has been steadfast in its assessment that the course of the economy remains contingent upon the course of the virus and, more recently, the pace of vaccinations. Committee members have reasons for optimism on both fronts. Two relief packages have been passed - totaling $2.8T - in additional aid and stimulus. Fiscal policy shouldering more of the burden of supporting the economy than the Federal Reserve with monetary policy: This did not happen in the wake of the 2008-09 recession; the result was not pretty.

Improvements will be reflected in the FOMC’s forecasts for economic activity. Look for significant upgrades to growth, somewhat higher inflation and lower unemployment in the outlook for 2021. We may also see more participants vote to raise rates in 2023, instead of later. In December, only six of 16 voting members of the FOMC expected one or more rate hikes by 2023; that number could move up to at least seven of 17 at the March meeting.

The hardest job for Fed Chairman Jay Powell is to clarify what the Fed actually means it says members are willing to “look through” a temporary flare in inflation this spring and summer. A sharp deceleration in inflation a year ago makes year-over-year measures easier to beat starting in March. Oil prices have moved up significantly after collapsing during the crisis. We should expect surge pricing on airfares and hotel room rates; the algorithms that set those prices are designed to rise with a jump in demand.

The question for Powell is what kind of inflation the Fed will deem as temporary, and for how long FOMC members will actually tolerate it. Is it 3-5% for a few months? Or less? Another unanswered question is what the Fed actually means by “average inflation” targeting. The FOMC has said it would like to overshoot on inflation a bit so that expectations move up to at least the 2% target. Committee members plan to raise rates once inflation has hit 2% and is poised to exceed it for a period of time. How long and how much of a rise in inflation will they actually tolerate?

The Fed reasons that a warmer economy would be a healthier economy, given the risks of disinflation we have battled. Higher inflation would justify higher short-term rates, which would allow more leeway to cut rates when we hit the next recession. The hope is to restore more of the Federal Reserve’s traditional tool kit - particularly interest rate shifts - after the pandemic has passed.

The problem is providing guard rails for those concepts in the real world. The bond market has already started to fear inflation, which is undermining the stimulus provided by low rates, notably in the housing market. Refinancing and purchase applications have already slowed in reaction to higher mortgage rates, which move in response to bond yields.

The Fed, for its part, believes it has the tools to counter any sustained increase in prices because that would require a sustained rise in wages. If that happened, Fed officials would happily raise rates to cool what would be an overheating economy for the first time in, well, decades. Seriously, that is how long it has been since we saw a vicious inflation cycle take root. That would mark a policy achievement for the Fed, rather than the failure the bond market is anticipating.

So much is unique about this crisis that we can’t completely rule out a more vicious inflation cycle. For now, the Fed justifiably feels it has the time and the tools to correct course if it goes wrong. We are a long way and a lot of policy mistakes from igniting the kind of inflation that took root in the 1970s. It is notable the role that the Nixon administration played in fueling those gains, including putting pressure on then-Fed Chair Arthur Burns to support the 1972 election. Yes, there are tapes.

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