Should the Federal Reserve Be Shifting Towards a More Restrictive Strategy?

Yes!

The November headline and core Consumer Price Index (CPI) figures rose by 6.8% and 4.9%, respectively, on a year-over-year basis. These numbers greatly exceed the Fed’s inflation targets even though the Fed focuses on the personal consumption deflator (PCE) instead of the CPI. But a recent survey by Oxford Economics of the top “country experts” covering 45 economies revealed that supply-chain disruptions could peak at the end of 2021. These disruptions have been a source of upward inflation pressures. At the time of this writing, the Baltic Dry Index (a measure of transcontinental freight costs is already down 39.3% from its peak in early October 2021). The second source of price pressures has come from labor supply bottlenecks. December 2021, U.S. Employment Report revealed that the labor supply bottlenecks are easing. Based on the Household Employment Survey, the U.S. Labor Force rose by 564k and 1.1 million jobs net-new-jobs were created in November. The U.S. Quit Rate (according to the latest JOLTS Survey) dropped to 2.8% in October 2021 versus a reading of 3.0% in September. It was the lowest U.S. quit rate since July 2021. And finally, even U.S. energy prices as measured by the West Texas Intermediate (WTI) oil price per barrel is off 19% from their peak levels earlier this year.

Additionally, the December preliminary University of Michigan inflation expectations appeared to stabilize as Consumer Confidence readings improved. The latest one-year and 5-to-10-year inflation expectations figures remained unchanged at 4.9% and 3.0%, respectively. Stated another way, the evidence suggests the Fed’s timing may be a bit off! With the benefit of hindsight, we can easily see that raising short-term rates sooner and more gradually would have been a far less risky policy strategy than waiting longer and then raising rates more aggressively. One can simply observe the shape of the yield curve, namely the difference between the 10-year U.S. Treasury rate and the 2-year Treasury rate, and observe that a narrowing or flattening of this spread is signaling that bond investors are becoming concerned that an overly aggressive strategy by the Fed could pose some risks to the longevity of the current economic expansion.

But we also need to cut the Federal Reserve some slack too. This year was not only a challenging year for the Fed to navigate through as multiple Covid-19 variants played havoc with the economic fundamentals, but it was more virulent on the political front. The Fed Chair had to make the right decisions while simultaneously having to navigate through the political landmines needed to assure his renomination for a second four-year term. Not only did Chair Powell have to convince the President to renominate him, but he also had to placate a polarized Senate (that needs to confirm his renomination) to give him the nod over Lael Brainard, a progressive contender at the Fed. With outright calls for his defeat by Senator Elizabeth Warren, Chair Powell had to err on the side of making sure no one was left behind even as inflation expectations (an important driver of future inflation) surged!

What was the correct course to take?

The correct course to take was precisely the course the Fed is now adopting to battle the risk of rising inflationary pressures. The only adjustment would have been to have adopted this course earlier and less aggressively. With diminished political pressures after his renomination, the Fed Chair has pivoted towards safeguarding the nation against outsized inflation pressures by adopting a more restrictive monetary strategy. Of course, this strategy could be easily modified if inflation pressures ease quicker than expected, but the Fed needs the optionality to proceed in this direction in case such pressures prove to be persistent.

The timing of such actions is what is suspect because it comes at a time where the peak in inflation may occur sometime within the next 6 months. If this strategy would have been adopted sooner, the peak in inflation may have been reached at lower levels. But given the political pressures of the day, it appears that the Fed Chair faced a Hobbesian choice. If Chair Powell would have chosen a strategy dictated by the economic fundamentals sooner, he may have risked being renominated for a second term. Unfortunately, the price for this political factor may be that the U.S. sees inflation peak at a higher rate than if it would have acted sooner.

How Could We Prevent This Problem in the Future?

One obvious solution is to have Congress consider increasing the term limit of Fed Chairs to an 8-year term with no opportunity to renew the position. Four years is too short for a Fed Chair to make a real difference in guiding the economic trajectory of a $23 trillion U.S. economy. To make a difference, we need to give the Fed Chair an opportunity to manage the Fed mandates of stable employment and price stability without the distraction of political forces!