The Fed Just Got Rid of Forward Guidance Because It’s Making It Up As It Goes
The Federal Reserve’s Federal Open Market Committee announced Wednesday it is raising its key policy rate—the federal funds rate—by 75 basis points to 2.5 percent. According to the FOMC’s press release, the committee recognizes that economic activity is declining, but that CPI inflation also “remains elevated”:
Recent indicators of spending and production have softened. Nonetheless, job gains have been robust in recent months, and the unemployment rate has remained low. Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher food and energy prices, and broader price pressures.
The committee goes on to state that with these conditions in mind, it will raise the target rate in order to “achieve…[CPI] inflation at the rate of 2 percent over the longer run.” Moreover, the committee states it “will continue reducing its holdings of Treasury securities and agency debt and agency mortgage-backed securities…”
There were not many surprises here. Most Fed watchers were predicting a 75-basis-point increase, and that’s what the Fed delivered.
This then leaves us with the question of “what now?” The Fed doesn’t know, and the weakness of the present economy will keep the Fed very cautious moving forward.
As was clear from Powell’s press conference Wednesday following the release of the FOMC statement, the Fed is still holding out hope for a “soft landing” in which it can significantly reduce inflation without sizably reducing employment or causing a greatly weakened economy.
How the economy will react to the Fed’s changes remains a complete mystery to the Fed, however, as has long been clear. It only took six weeks, after all, for the Fed to go from a stance of “economic activity appears to have picked up” (at the June meeting) to July’s report of how “recent indicators of spending and production have softened.”
The Fact the Fed has no idea how things will go in response to Fed policy is emphasized by Powell’s admission that the Fed isn’t planning to offer any more forward guidance this year, which frees up the Fed to make more last-minute decisions and more aggressively make things up as it goes. Specifically, Powell said that moving forward “we think it’s time to just go to a meeting by meeting basis, and not provide the kind of clear guidance that we did on the way to neutral.”
Translation: “things might go even more off the rails at any time, so let’s just play it by ear.”
Powell further emphasized that he believes the US is not currently in recession and that “we’re [i.e., the Fed policymakers] not trying to have a recession and we don’t think we have to.” Powell, however, admitted that the possibility of successfully pulling this off requires walking a very narrow path. Moreover, as Powell recognized “growth is going to be slowing down this year,” the path to reducing CPI inflation without a recession “has narrowed” and may “narrow further.”
The Fed Bravado Is Gone
These are not the words of a man with much confidence he can do what the Fed has long promised it would do. The Fed line for years has been that it would “not allow” inflation to rise much above its two-percent standard, and that the Fed has “many tools” to ensure this doesn’t happen. All that big talk is now long gone.
Nor would Powell say what he would do if the economic situation worsened. When asked by CNBC’s Steve Liesman about what standard Powell was using to determine how the Fed should react to worse economic news, Powell didn’t attempt any real answer, and simply reiterated that the focus is inflation.
That the Fed is clearly worried about the slowing economy was apparent in just how little the Fed has actually done to tighten monetary policy in recent weeks.
Fed Policy In Context
A target rate of 2.5 percent doesn’t even exceed the Fed’s timid rate hikes of 2019. Moreover, when the Fed hiked rates in 2019, the Fed’s portfolio was at only $4 trillion. Total assets have doubled since then, and the fed has done virtually nothing to reverse this. In other words, a target rate of 2.5 in 2022 means a lot less than the same rate in 2019, given the easy-money cushion provided by a Fed portfolio that’s twice as large now.
Politically, today’s rate hike may be enough to allow the Fed to claim it is doing something about inflation. After all, the Fed can claim the fed funds rate is now at the highest it’s been at any time since 2008. At can also claim it is allowing its assets to roll off the balance sheet although after months of hawkish talk about the balance sheet, the Fed’s assets have only been reduced by less than one percent.
The question now is how long it will take the Fed to throw in the towel and “pivot” to a loosening stance due to fears over a new recession. Given the Fed’s chickening out in 2019—when it backed off rate increases after hitting only 2.5 percent—one might reasonably believe that it won’t take much for the Fed to return to “stimulus” as soon as the economic news gets even slightly worse.
A quick turn back to loosening, however, could further imperil the Fed’s credibility which has been greatly damaged in recent months as the Fed has consistently fallen behind the curve on inflation. As Mohamaed El-Erian puts it, there are fears that the Fed is returning to the “stop-go Fed of the 1970s.” That is, people are worried this Fed is like the Fed of Arthur Burns which never really addressed the easy-money-fueled price inflation of the 1970s and let the problem snowball until the early 80s.
Powell himself may have made a nod to this in Wednesday’s press conference when he acknowledged that a refusal to address price inflation now just “raises the cost of dealing with it later.”
As with last month, however, Powell was unable or unwilling to offer any reason for why 75 basis points was the “correct” increase in the target rate—as opposed to 100 basis points, or 200, or zero. That’s just a number the committee made up.
Ultimately, it’s all just more tinkering, and what the Fed should be doing is stepping way back from monetary policy and stop “setting” the interest rate altogether. The Fed’s open market operations should be ceased, allowing the marketplace to discover what the real market interest rates actually are. That, unfortunately, is not on the Fed’s list of options.