When the Federal Reserve changed its framework for monetary policy in August, 2020, it sounded to me like an over-reaction to the pandemic era economic malaise. Looking back, I describe that moment as peak deflationary thinking. This peak is marked by an assumption that the economy is stubbornly stagnant and biased for lower aggregate prices without the Fed’s on-going vigilance and active interference. It turned out that the pandemic delivered just the right mix of sustained economic distortions and excessive liquidity to create “persistently elevated, unactionable inflation“. In December, 2022, I explained the Fed’s challenge and the attempt at course correction in “How To Trade The Fed’s Designed Over-Correction For Inflation“:

“In the immediate aftermath of the pandemic, the Fed announced an important policy shift at that year’s Jackson Hole gathering. Going forward, the Fed would target average inflation of 2% instead of 2% as a point destination. Moreover, the Fed crystalized its goal to drive unemployment as low as possible via ‘assessments of the shortfalls of employment from its maximum level.’ Years and decades of deflationary drags facilitated this shift, and the economic crisis from the pandemic seemed at the time to further entrench these deflationary forces. Interest rates seemed destined to stay lower for longer…I claim this policy framework encouraged the Fed to be overly optimistic about the transitory nature of pandemic-era inflation, and subsequently compelled the Fed to move late toward normalizing monetary policy.”

My claims that the Fed left rates too low for too long in its ambitious effort to drive unemployment as low as possible received a resounding validation in “The Inflation Surge of the 2020s: The Role of Monetary Policy,” a “conference draft” authored by economists Gauti B. Eggertsson (Brown University) and Don Kohn (Hutchins Center on Fiscal & Monetary Policy, Brookings Institution). Eggertsson presented the paper on May 23, 2023 during a 3-hour conference at the Brookings Institution titled “The Fed: Lessons learned from the past three years” (Eggertsson’s 27-minute portion starts at the 1:25 mark).

How the Fed’s Revised Policy Framework Contributed to the Inflation Surge

In this paper, Eggertsson and Kohn explore how the Federal Reserve’s monetary policy contributed to inflationary pressures in the U.S. between 2022 and 2023. In their research, they describe the inflation surge that began in March 2021 as “the largest and most persistent increase in inflation since the Great Inflation of the 1970s.” This inflation surge was unanticipated and its persistence was consistently underestimated by policymakers and economists (as well as a wide array of pundits and analysts who invariably insisted that high prices would be sufficient brakes on demand to cure inflation before economic damage occurred).

Just as I claimed the 2020 Policy Framework was the genesis of the Fed’s monetary problem with inflation, the authors did the same. They note that there were two major changes in this Framework from the 2012 version. The first change was the adoption of the Flexible Average Inflation Targeting (FAIT). This policy states, “if inflation persistently undershoots the 2 percent target it will be offset by deliberate ‘moderate’ overshoots ‘for some time’ to better assure that inflation averages 2 percent over time.” The second change was the shift to an asymmetric response to labor market deviations from “maximum employment.” This means that policy would be influenced by shortfalls from maximum employment rather than estimated or projected overshoots. Importantly, Eggertsson and Kohn propose that “an asymmetric objective function, coupled with the common assumption that policy affects activity with a lag, implies an inflationary bias.” (The paper’s appendix includes a mathematical representation of this claim).

The authors suggest that the new Framework was largely predicated on the belief that the tightness of the labor market had a limited impact on inflation. This belief was informed by the 2015 experience when unemployment declined from 5.0% to 3.7% while inflation was still undershooting the 2% target. Extrapolating from this lesson, the 2020 Framework assumed employment could expand for longer without generating inflationary pressures. Thus, there was no need to reduce accommodation preemptively as the labor market tightened.

The authors critique the 2020 Framework’s reliance on reaching maximum employment and inflation at or above 2% before increasing interest rates. This precondition led to what they call “additional inertia to the policy process,” as it limited the Federal Reserve’s ability to adapt to unexpected economic circumstances. The authors note that “forward guidance in September 2020 was well designed to avoid a repeat of a pre-emptive tightening after 2015 when there was high employment but low inflation, it was less well suited for a situation in which it was the other way around.” The forward guidance in September 2020 took its marching orders from the newly updated Policy Framework.

The inflation surge of the 2020s, beginning in the first quarter of 2021, was a sudden and underpredicted economic event. The authors observe that even after the inflation surge began, “Policy makers and the professional forecasters persistently predicted inflation to fall back toward the 2 percent target reasonably promptly.” Base effects from the brief plunge in prices after the pandemic also clouded assessments of the inflation risks. Yet, as the authors explain, “By some metrics the inflation objectives of FAIT (flexible inflation targeting) had been reached in the spring of 2021.” The Fed did not start to hike rates for another year.

Hawkish Hints Were Not Sufficient to Fight Inflation

While the Fed failed to hike rates for that year, they DID drop some hints that inflation was becoming a problem. Eggertsson and Kohn provide a timeline showing the snail’s pace of change in the Fed’s statements on monetary policy over that time, but they use it to explain the lag in policy. Statements between meetings reveal some increasing concerns despite the reluctance to act. For example, in June, 2021, I described how statements from Fed Chair Jerome Powell during the monetary policy press conference that month combined with post-meeting commentary from James Bullard, the president and CEO of the Federal Reserve Bank of St. Louis, to give the Fed a hawkish bias. Yet, despite the expressed surprise at the strong trajectory for inflation, Powell reassured the audience that “lift-off” for rates would leave policy accommodative…just as the 2020 Policy Framework counseled them to act.

The authors reference Robert Kaplan of the Dallas Fed, a dissenter to the September 2020 forward guidance, as an early voice of caution that the Fed apparently decided to ignore. Kaplan co-authored a paper with other researchers at the Dallas Fed in May, 2021 that concluded the labor market was much tighter than indicated by traditional metrics. Eggertsson and Kohn lament that the warning “…seemed to have little effect on the official narrative of the FOMC at the time.” I am not surprised given the weak conclusion of the paper. The following quote reads like an advisory or footnote instead of a prescription or recommendation for a policy change:

“In this post, we wish to suggest that policymakers should be cognizant of a range of supply factors that may currently be weighing on employment. These factors may not be particularly susceptible to monetary policy.

We would expect that many of these factors will fade as the year progresses, increasing the number of job seekers and potentially reducing labor market tightness. However, it is also possible that labor supply will increase less than expected. It is our view that this possibility should be kept in mind as policymakers assess the appropriate stance of monetary policy.”

Note how Kaplan et al even provide an out for monetary policy to stand by and do nothing by suggesting that factors weighing on employment supply are outside the sphere of influence of monetary policy. They did not take the extra step of suggesting that monetary policy was overly accommodative given the inflationary structure of the economy. Their hints were not sufficient.

To wit, with rising speculation about the timing for rate hikes, Powell stuck his neck out in August, 2021 to issue reassurances. Whatever hawkishness hovered over the Fed evaporated in that moment. The Fed would remain focused on tapering with no implication for rates. The hints of hawkishness were simply not sufficient. They did not and could not serve as inflation control.

The focus on tapering also created drag on monetary policy. Eggertsson and Kohn pointed out that the completion of asset purchases became a prerequisite for raising rates. This condition not only resulted in an unnecessary delay but also committed the Federal Reserve to providing far-in-advance notice on how and when asset purchases would be completed.

The Labor Market Was Sufficiently Tight

As the Fed dragged its feet, the labor market tightened to historic levels. The unemployment rate did not tell the full story. Eggertsson and Kohn show how the vacancy-unemployment ratio (v/u) shot up to 0.88 by March, 20221. This level was higher than the average ratio pre-pandemic. The ratio kept climbing persistently and sharply from there. It surpassed 1 by May 2021 and went over 2 by the time the Fed finally started hiking rates in March. The vacancy-unemployment ratio was last that high during World War II. The consistent and linear increase in the first 2 years of the pandemic is truly astonishing.

Source: Eggertsson and Kohn

The authors also stress the importance of understanding the non-linearity of the Phillips curve, an economic principle that shows the relationship between unemployment and inflation. If the labor market was tight enough for these non-linearities to become quantitively significant, this “tightness of the labor market, as measured by v/u, not only gave the Federal Reserve a reason to declare it had satisfied the forward guidance of September 2020” but also indicated that failing to recognize this tightness could have been a major source of the inflation surge.

The Inflation Overshoot

By the time Powell spoke about excessive inflationary pressures in the days after the first rate hike, inflation was well into its overshoot. According to the authors, commitments to the new Policy Framework combined with the uneven and unprecedented nature of the recovery created an inflation overshoot. This inflation overshoot did not have a clear boundary due to the newly imposed condition of achieving maximum employment before raising rates. Additionally, gauging maximum employment was considerably challenging due to the uneven nature of the recovery. Traditional metrics, such as the unemployment rate, proved to be poor proxies for maximum employment under these circumstances. The Fed unwittingly locked itself into implementing the most aggressive campaign of rate hikes since the Paul Volcker days of the early 1980s.

Conclusion: Lessons Learned?

In late November, 2022, Powell claimed he learned his lessons from what I call peak deflationary thinking. In commenting during the Q&A at a Brookings Institution conference at the time, I made the following observation:

“Powell suggested that he would not repeat the ‘mistake’ of counting on the long history of low inflation as a basis for making policy. Powell noted that policy must take into consideration tail risks and their costs. Such acknowledgement forms the foundation of today’s risk management framework. However, Powell remained consistent with earlier Fed claims that starting monetary tightening earlier would not have materially impacted the path for inflation. He insisted that the mistake from two years ago has nothing to do with today’s inflation; he relegated the mistake to a footnote.”

With this attitude, the Fed is not likely to learn the lessons Eggertsson and Kohn hope the Fed takes away from this experience. Instead, the new risk going forward is that the Fed concludes the current Policy Framework just got “unlucky.”

Still, Eggertsson and Kohn are hopeful. Moving forward, they suggest that the next policy framework should be subjected to a variety of stress tests and scenarios. Also, in the next framework review, a central question should be whether the benefits hoped for by evaluating deviations of employment from its maximum level can instead be addressed by alternative tools and techniques.

Eggertsson and Kohn also explain, “Like the criteria for adjusting policy, forward guidance needs to build in flexibility in timing and sequencing to adapt to changing circumstances.” They further note that forward guidance and the policy it implies should not only focus on achieving the Federal Reserve’s goals at a particular point in time but also maintaining prices and employment around those goals after they are reached.

Perhaps ironically, these suggestions sound like a data-dependent orientation which the Fed typically professes to follow.

During his presentation, Eggertsson admitted that he was formerly on “team transitory.” A Japanese paper even interpreted him as saying that inflation was not a problem, the proverbial “there is nothing to see here.” His research and retrospective have dramatically changed his understanding and conclusions. Yet, I think he and his co-author are too charitable in claiming that “with the benefit of hindsight, we see several broad problems with the framework and forward guidance that leads to lessons learned for the future frameworks and policy execution.” Their work decisively demonstrates that the necessary signals, signs, and data were readily available for the Fed to act upon sooner. The Fed was anchored by its commitment to a Policy Framework with an inflationary bias. Going forward, policy frameworks must be much less gospel and much more responsive.

Today’s Fed is in risk management mode out of necessity. While people can endlessly debate about the risks and their quantification, this kind of circumspection is an appropriate response to this era of heightened economic uncertainty. Noble goals like driving unemployment down as low as possible in the short-term must take second seat to practical goals like sustaining long-term financial stability.

Be careful out there!

The post Why Monetary Policy Was Late In Responding to the Pandemic-Era Inflation Surge appeared first on Inflation Watch.

The S&P 500 (SPY) rallied enough to punch through two important resistance levels. The cumulative losses from Jackson Hole are now almost reversed. (Source: TradingView.com)

If not for the stock market’s reaction, I would have interpreted Powell’s speech to land somewhere between hawkish as ever and no new information. In fact, there were several key points from the speech which should have told the market the Fed is as serious as ever about sustaining an extended fight against inflation (the following are direct quotes unless otherwise indicated; particularly important quotes in bold):

• It will take substantially more evidence to give comfort that inflation is actually declining. By any standard, inflation remains much too high.
• So when will inflation come down? I could answer this question by pointing to the inflation forecasts of private-sector forecasters or of FOMC participant…But forecasts have been predicting just such…a decline for more than a year, while inflation has moved stubbornly sideways.
• It seems to me likely that the ultimate level of rates will need to be somewhat higher than thought at the time of the September meeting and Summary of Economic Projections. (a reiteration from the November monetary policy meeting)
• Restoring [supply and demand] balance is likely to require a sustained period of below-trend growth. (another reiteration)
• Despite the tighter policy and slower growth over the past year, we have not seen clear progress on slowing inflation. 
• It is far too early to declare goods inflation vanquished, but if current trends continue, goods prices should begin to exert downward pressure on overall inflation in coming months. (the stock market must have focused on this claim)
• As long as new lease inflation keeps falling, we would expect housing services inflation to begin falling sometime next year. Indeed, a decline in this inflation underlies most forecasts of declining inflation. (in other words, this claim is old news)
• We can see that a significant and persistent labor supply shortfall opened up during the pandemic—a shortfall that appears unlikely to fully close anytime soon. (the stock market clearly did not hear this)
• The labor market, which is especially important for inflation in core services ex housing, shows only tentative signs of rebalancing, and wage growth remains well above levels that would be consistent with 2 percent inflation over time. (in other words the job market is at risk of sustaining high rates of inflation)
• Despite some promising developments, we have a long way to go in restoring price stability.
• It makes sense to moderate the pace of our rate increases as we approach the level of restraint that will be sufficient to bring inflation down. The time for moderating the pace of rate increases may come as soon as the December meeting. (this is another reiteration, but the stock market seemed to treat this as welcome new news)

If the Fed Fund futures market reversed course and priced in lower peak rates, the stock market’s sudden burst of enthusiasm could have made more sense. However, futures speculators just shifted out the peak 5.00%-5.25% range by one meeting, from March, 2023 to May, 2023. The market did move up the schedule for the first rate cut and ended the year at 25 basis points lower. However, note well that during the Q&A Powell reiterated a warning about the market’s expectations for quick rate cuts: “Cutting rates is not something we want to do soon. That is why we’re slowing down.”

Fed Fund futures market peaked rates at the March, 2023 meeting ahead of Powell’s speech (source: CME FedWatch tool)

Fed Fund futures market peaked rates at the May, 2023 meeting after Powell’s speech and moved the first rate cut up by 5 months (source: CME FedWatch tool)

The day’s rally in the stock market is one of those many times to ignore contrary fundamental assessments and pay attention to what the market thinks. If buyers follow through with the 200DMA breakout on the S&P 500, I will assume seasonal tailwinds are in full flight. Absent any shocks, the market could then rally all the way into the Fed’s December 14th pronouncement on monetary policy. That event will give Powell a fresh chance to redirect financial markets if financial conditions loosen up too much by then. Maybe Powell will have to reiterate how the Fed will “keep at it” instead of “staying the course.”

The Q&A of the Brookings Institution session mainly reiterated points from the speech. There were two points that stirred my interest for future reference.

First of all, Powell actually admitted that the housing market was in a bubble. The conditions he described were easily observable at the time: “coming out of the pandemic, rates were very low, people wanted to buy houses, get out of the cities and move to the suburbs. You had a housing bubble. Had prices going up that were very unsustainable levels, and overheating…” However, of course, the Fed did not dare say the “B” word in the middle of the mania. Powell did not offer any thought on whether the bubble could have been moderated by hiking rates sooner…or at least jawbone about the bubble.

Secondly, Powell mentioned one regret from the 2020 policy framework reset that he mentioned almost as a footnote. Powell indicated that he would not repeat the mistake of relying on a long history of low inflation as a basis for making policy. At the reset, Powell communicated that the Fed would not “lift off” (start hiking rates) until it “saw both maximum employment and price stability.” The stock market soared on this news as it correctly interpreted the change as a Fed more tolerant of a higher range in inflation. Powell admitted that commitment “made us under-estimate tail risk.”

I soundly criticized this pronouncement at 2020’s Jackson Hole. While Powell insisted this mistake has nothing to do with today’s inflation, I continue to insist that this commitment made the Fed slow to respond to rising and then realized inflation risks. Members of the Fed have also dismissed the notion that starting rate hikes a little earlier would have made a material difference in the inflation landscape. We will never know the counterfactual of course. Still, I feel somewhat vindicated that the Fed has taken note of its policy mistake (and prior deflationary bias) and learned some lessons.

Be careful out there!

Appendix: Notes from the Q&A session

Wage increases are going to be a core part of the inflation story going forward.

The labor market has a real supply imbalance

For most workers, wage increases are being eaten up by inflation. Need price stability to get real wage increases.

We assumed that the natural rate of unemployment had gone higher during the pandemic. It’s very hard to pin down where it is when there is a massive disruption.

Used to be able to look through supply shocks. But if we have repeated shocks, it changes things. What are the implications if true? Very hard to know the answers. We tend to think things will return to where they were naturally, but that’s not happening.

Need to be humble and skeptical about inflation forecasts for some time, calls for a risk management framework. If you are waiting for actual evidence for inflation coming down, it is possible to over-tighten. Slowing down is a good way of balancing the risks.

Very few professional forecasters have gotten inflation right.

There isn’t any one summary statistic to determine when policy is sufficiently restrictive. We monitor the tightening of financial conditions (which happens based on expectations). We also look at the effect of these conditions on the economy. Look at the entire rate curve. For significantly positive real rates along the entire curve. Forward inflation expectations reflect confidence in the Fed getting inflation down to 2%. Look at exchange rates, asset prices. Put some weight on these things.

How do you know when you can stop shrinking the balance sheet? This has already been described in a document. We’re in an ample reserves regime. General changes will not impact the funds rate. Will allow reserves to decline until somewhat above where we think is scarcity. Hold the balance sheet constant….. The demand for reserves is not stable. It’s a public benefit to have plenty of liquidity.

Question: August, 2020 announced new flexible inflation targeting framework. Anything in that we should be rethinking. Answer: We will do another review in 2026 or 2026. We implemented through guidance of various kinds. Put in strong guidance because there were a lot doubters that we could ever achieve 2%. Neither did we know. One piece of guidance we wouldn’t do again (it doesn’t have anything to do with the inflation we are currently seeing): we wouldn’t lift off until see saw both maximum employment and price stability. It made us under-estimate tail risk. Remember 25 years of low inflation, inflation just didn’t seem likely.

Cutting rates is not something we want to do soon. That is why we’re slowing down.

It’s not reasonable to expect we get back to the labor force participation in 2020 before the pandemic. But I wouldn’t rule it out. It’s been disappoint and surprising how little we’ve gained back.

We have to assume that for now most of the labor force balancing has to come on the demand side. By slowing job growth, not putting people out of work.

At what point do people ask for more wages because they aren’t keeping up with inflation. Don’t know when that happens, but if it does, you’re in trouble. Labor shortage is not going away anytime soon.

Coming out of the pandemic, rates were very low, people wanted to buy houses, get out of the cities and move to the suburbs, You had a housing bubble. Had prices going up that were very unsustainable levels, and overheating, now the housing market is coming out the other side of that. We have a built-up country, we have zoning, it’s hard to get homes built to meet demand

Full disclosure: long SPY call spread

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