It was like an emergency responder rushing to the scene of an accident. The Federal Reserve took less than two weeks to slash interest rates to zero and unveil its largest bond-buying program in history when the coronavirus pandemic first bulldozed into the economy.
But a financial system that’s now on the mend is in no way lessening the burden of the U.S. central bank’s job: steering the world’s largest economy out of a recession but away from overheating and other downside risks (like the Delta variant) by determining how much you pay to borrow and how much you’re paid to save.
The Fed at this point is expecting to lift borrowing costs from their rock-bottom levels in 2023, and on deck is another key policy change: slowing down their massive asset-purchasing program worth at least $120 billion a month, which could potentially lift interest rates on other longer-dated debt, such as mortgages.
“Inflection points are really hard,” says Vincent Reinhart, chief economist and macro strategist at Mellon who spent 24 years at the Fed. “When you’re going down a straight road, you can go really fast, and you know what to do when the unemployment rate is double digits. Fed communication is easy at that point because everybody agrees to the problem. … But if the driver has said, ‘No, I’m going to wait until we see the yellow caution signs on the road before I slow down,’ you may have more concerns.”
Consumers are starting to see inflation, and that could threaten the Fed’s patience
Consumer prices in July rose 5.3 percent from a year ago, marking the fourth straight month that inflation had increased by the fastest pace in 13 years.
Americans and investors are also expecting prices to climb higher than at any point in the past decade, though trackers of their inflation expectations have since moderated from their recent highs.
The Fed’s mantra for months now has been that any inflation surge will be temporary, broadly reflecting reopening flukes. Officials are expecting that demand will balance back out with supply, bottlenecks will clear and below-average readings from last year will fade, all of which were responsible for making this month’s year-over-year jump look so significant.
Fed officials in their latest economic projections see prices rising above target this year, then moderating back down near 2 percent in 2022 and 2023.
“To the extent people are implementing price increases because raw materials are going up or labor costs or something is going up, the question for inflation really is, does that mean they’re going to go up the next year by the same amount?” Powell said during a July press conference, describing what he means by transitory inflation. “I don’t mean that producers are going to take those price increases back.”
A persistent upward movement in inflation could create an environment similar to the Great Inflation of the late 1970s and early 1980s, a lengthy period where prices skyrocketed after years of big government spending on the Vietnam War, two oil shocks and a too-accommodative monetary policy. Back then, the Fed had to manufacture a recession to get prices back on track by raising interest rates to intentionally slow down the economy.
Former Treasury Secretary Larry Summers warned in May that the Fed is laying the groundwork for another high-inflationary period, calling the Fed’s patience stance a “dangerous complacency.”
Yet, the Fed is unlikely to see one month’s worth of a price burst as a sign that the Great Inflation is here again, experts say.
“It took 15 years to get to the peak, where inflation expectations were out of control and the Fed stepped in with a recession,” says David Beckworth, senior research fellow at the Mercatus Center at George Mason University and a former Treasury Department economist. “Even if we are reciprocating the 1970s like Larry Summers claims, it’s a long journey. It’s not going to happen overnight.”
Beckworth adds that a sustained period of inflation above 2 percent for at least a year might be enough to warrant a rate hike.
But the longer prices continue to rise, the trickier the situation could get for the Fed. Consumers’ opinions on where prices are going to rise have a lot to do with the current inflation rate, meaning inflation expectations could perk back up the longer prices keep climbing.
Rising inflation expectations could prove to create the inflation that’s feared all along. That’s because it gives businesses more wherewithal to hike prices and workers more room to ask for higher pay if the general public starts to expect that their money won’t be worth as much.
Bill English, finance professor at the Yale School of Management who spent more than 20 years at the Fed, calls it “the dealbreaker” — especially if expectation gauges across the board move up by more than a few tenths. “At that point, they might feel that they have to pull back more quickly than they had intended. It could go too far, and that is the risk,” he says.
“If we saw signs that the path of inflation or longer-term inflation expectations were moving materially and persistently beyond levels consistent with our goal, we’d be prepared to adjust the stance of policy,” Powell also said in July.
Before the Fed raises interest rates, expect this key policy change
Another factor that could ultimately delay the Fed’s rate-hike timeline: its asset purchases.
When a downturn is severe enough, the Fed won’t just slash interest rates to zero but also buy government-backed debt on the open market. That helps push down the longer-term interest rates that aren’t traditionally influenced by the Fed’s main policy lever, the federal funds rate.
The Fed each month is currently purchasing $40 billion worth of mortgage-backed securities and $80 billion a month of Treasurys. That’s provided an extra form of economic stimulus by weighing on mortgage rates, fueling a refinance and housing market boom with borrowing costs sinking to some of their lowest levels in history.
But the Fed has already made it clear that it’d like to stop buying assets before hiking interest rates, mainly because the two policies would contradict each other.
Yet, the Fed is still mulling over when the economy might be able to stand on its own two feet without the extra juice. Officials have said they’d like to see “substantial further progress” on their two economic objectives — stable prices and maximum employment — by the time they back away from their bond-buying program.
While inflation has risen, the job market is still being held down by labor shortages and work disruptions as virus cases, enhanced unemployment benefits and child care issues combine to keep workers on the sidelines.
About 3.1 million people have dropped out of the labor force since the start of the pandemic, and up in the air is how many of those exits became permanent. Some workers might have realized they could get by with fewer people working in their household, while others may have decided to retire early. The unemployment rate has steadily declined to 5.4 percent from 14.6 percent, yet the U.S. economy is still short some 5.7 million jobs compared to pre-outbreak levels.
Virus resurgence a downside risk to the economy
Virus variants could also derail progress, bringing back restrictions that could hold the economy back. And even without formal lockdowns, consumers may already be growing apprehensive about dining and shopping outside of their homes again, with retail sales in July falling by 1.1 percent as fears about the virus mounted and government stimulus dried up. On the other hand, factories could close both in the U.S. and abroad if virus cases continue to surge, further dismembering supply chains and exacerbating inflationary pressures.
Fed officials in July admitted that the economy had shown progress, while records of their July meeting showed that “most” participants said a bond-buying slowdown could be warranted this year.
When that time comes, however, rate hikes might not exactly be around the corner. “It would be important that the committee clearly reaffirm the absence of any mechanical link between the timing of tapering and that of an eventual increase in the target range for the federal funds rate,” according to the July Fed meeting minutes.
“There are going to be a lot of crosscurrents, and it’s not going to be a one-way stream,” says Rhea Thomas, senior economist at Wilmington Trust. “They will hold off on withdrawing policy as much as they can to avoid harming the labor market recovery, but it will be the virus that determines whether those rate hikes get pushed further out or are faster than expected and depend on inflation expectations.”
If the Fed arrives ‘late to the party,’ experts say you might have to brace for faster and more aggressive rate hikes
Experts say the longer the Fed waits to take the punch bowl away from the economy’s party, the bigger the likelihood that they might have to shut down the boom more quickly. That might mean a faster pace of borrowing cost increases at a bigger rate to get inflation and economic growth under control.
That would be in direct contrast with the gradual rate-hike rhythm Fed officials found after the Great Recession of 2007-2009. The Fed hiked rates nine times throughout the decade-plus expansion, though later walked back three of those increases in 2019.
“If you push back an awful long way, then there’s really some probability that you have to raise rates pretty fast, depending on, of course, what the economy is doing,” English says. “Markets will potentially have to get comfortable with that, but for now, we just don’t know.”
The Fed “is coming late to the party, but that’s by design,” Beckworth says. Coronavirus pandemic aside, the U.S. central bank is now juggling its twin goals — maximum employment and stable prices — differently. In plain English: The Fed is now willing to stomach higher inflation for longer periods of time to let the job market run hot, leading to lower-for-longer interest rates.
“Imagine a world where you didn’t have the pandemic happen,” Beckworth says. “The Fed’s new framework would still require some amount of temporary inflation overshoot intentionally, if there’s been a recession.”
Officials might also not want to risk getting the next rate-hiking cycle wrong. The Fed knows that raising interest rates too soon risks needlessly slowing down the economy, keeping millions of Americans jobless who would’ve otherwise found employment if the financial system had a bit more time to grow.
“Their policy tool is asymmetric,” Reinhart says. “If they get it wrong and convey a sense of tightening too soon and the rebound lags, there’s not a lot they can do other than push out when they would ultimately remove that accommodation. They get it wrong on the other side, inflation expectations rise, they’ve got tools at a later date to deal with it.”
It’s a tricky juggling act moving forward for Powell, who won’t want to spook investors by brushing the economic rebound under the rug or prime them for a rate hike before the economy is ready.
“The front-end risk is that investors come to expect inappropriate policy tightening too soon; the back-end risk is that investors come to expect inappropriate delay in policy tightening. Powell is more worried about the front-end risk than the back-end risk,” Reinhart says. “From a central bank’s perspective, raising rates is either a thing they look forward to or they really, really worry about. When the date comes, the Fed will raise rates because it will be the economy forcing them to do it.”