There are risks to the economy and financial stability associated with the recent adoption of the high-for-long slogan by US central bank officials.
Jerome Powell, the chair of the Federal Reserve, watching the statistics.
Regardless of their historical classification as "doves" or "hawks," Federal Reserve officials have lately shown a striking consistency in their signaling of high interest rates for extended periods of time. This has happened at a time when an increasing number of Wall Street experts are projecting economic growth and inflation within a broader range of uncertainty. Three hazards to financial stability and economic success are brought up by this circumstance.
Fed policymakers have changed their earlier predictions for constantly easing pricing pressures after a run of hotter-than-expected readings for all the key inflation indicators in the first quarter. Last week, Chair Jerome Powell succinctly described this change in his outlook for reduced inflation, stating that it is "not as high" as it was at the beginning of the year.
In light of a more sobering assessment of inflation and in light of a detrimental misrepresentation of inflation as "transitory" in 2021, recent remarks by Fed officials have consistently emphasized the need of extending the period of time that restrictive monetary policy may be effective. Reversing their earlier forecasts of rate reduction, the authorities said that the less alarming inflation data from April did not provide enough of a confidence boost. In fact, before lowering rates, Fed policymakers are waiting for "several more" strong inflation readings, as Governor Christopher Waller said on Tuesday.
Such consistency comes at a time when trust in the Fed's wisdom and efficacy has already been eroded, so the economy and markets are not guaranteed a smooth ride going forward. Three hazards do, in fact, stand out.
The first is related to the Fed's policy approach, which has become overly and, in my opinion, unduly reactive. This approach is known as "data-dependent" policymaking, to use the Fed's most often used term these days. Due to this, the central bank changed its tone to one that was more dovish in December of last year, which gave the markets the confidence to price in six or seven rate cuts for this year. The market currently expects just one or two cuts, after the pivot caused by a run of positive inflation readings that were followed by less encouraging data in the first quarter and a continuous U-turn.
An approach this reactive is troublesome in a world where there are so many unknowns. For an organization whose residual inflationary forces are less susceptible to interest rate changes and whose policy instruments operate slowly, the situation is far more troubling.
The second issue is that an increasing number of businesses are expressing worry about declining consumer demand at the same time as the U-turn. This is especially true for those working with lower-class homes, where credit card balances have increased, where savings have been completely emptied, and the ability to take on debt has reached or is almost at its maximum. The economy is becoming more dependent on the resilience of the labor market as its only and most important safeguard against an uncomfortably high possibility of recession as the weakness at the lower end of the income ladder starts to move up.
The third concern is that the 2 percent inflation goal, which is out of date, is being used to calibrate the Fed's policy signals. Recall that 2 percent is not the result of some highly developed econometric model that aims to determine the ideal amount of inflation at which to achieve a stable state that is both compatible with the structural facts of the economy and the Fed's other mission (employment). Instead, it's an arbitrary goal that was first established in New Zealand in the 1990s, and the Fed embraced it after the Bank of England and the European Central Bank, among others. This goal turned out to be mostly non-binding in a world where positive supply shocks were abundant and central bank credibility was firmly established thanks to the illustrious Fed head Paul Volcker.
As I have previously said, a domestic economic strategy that is not based on the liberalization, deregulation, and budgetary restraint of the "Washington Consensus" may find 2 percent to be an unrealistic goal. In the US, the paradigm for economic policy that we live in is quite different. You need only take notice of the abnormally large budget deficit that coincides with 27 consecutive months of unemployment below 4 percent, the growth of industrial policy, and the necessary expenditure to support government programs that have been announced.
Another factor posing a threat to the 2 percent inflation objective is a shifting global paradigm. The pursuit of ever-closer integration via uber-globalization has given way to trade and investment instrument weaponization and fragmentation. Once again, this is causing secularly deflationary winds to change to inflationary ones.
Because of these three concerns, the present Fed viewpoint homogeneity has the potential of unduly impeding growth, particularly if it is maintained for an extended period of time. A downturn in the most powerful engine of world economic growth would be accompanied by increased currency and interest rate volatility, which would target highly indebted sectors of the economy like commercial real estate, which still lacks a feasible means of refinancing or a systematic way to dispose of its assets.
I don't think the issue of future monetary policy should be whether the Fed will reverse course once again. For a central bank that still has a strategic foundation and will respond sluggishly to economy slowing more than officials anticipate or find acceptable, another U-turn is very probably in the works. Whether this happens in time to prevent major financial and economic harm, especially to the most vulnerable populations, is the crucial issue.
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