The first debate is whether the sudden tightening will eventually result in a recession in the US economy? The second, and more strategic debate, is whether the Fed had pushed off the rate hike decision for too long. Larry Summers pointed out that the rate hikes should have started when inflation was at 4% and not when inflation had touched 8.5%.
The second aspect of whether the Fed took too long to hike rates has been addressed in elaborate detail by Fed Governor, Christopher Waller. In his speech at the Hoovers Institution, Waller underlined that decisions look simplest when viewed in the rear view mirror. However, actual decision making is a different ball game altogether.
How the Fed got so far behind the curve in hiking rates?
In his speech at the Hoovers Institution, Waller has made 3 important points on this subject of whether the Fed fell behind the curve. Firstly, Waller pointed out that the Fed was not alone in underestimating the intensity of inflation, which manifested fully only in late 2021. The second point made by Waller is that, in practice, the rate hike decision is never taken based on inflation alone.
While rising inflation was a reality, the actual rate hike decision can only be taken with confirmation in the form of a strong labour market and rising wages. Lastly, Waller has pointed out that the Fed is not driven only by high-frequency indicators but secular indicators which are evident only once the data revisions are done. That takes time.
Dilemma of dual mandates for the Fed
Regarding the back-ending of rate hike decision, Waller pointed to two policy dilemmas that the FOMC has to live with.
Moving from transitory inflation to substantial progress
When the long term monetary guidance was laid out by FOMC in September 2020, the priority was to keep rates close to zero and sustain asset purchases so that the US economy could show balanced recovery. It was only in March 2021 that it first became clear that inflation was staying well above the 2% mark with no signs of tapering any time soon.
In 2021, inflation in the US witnessed two diverse trends. After inflation showed signs of spurting in March 2021, it held high till June 2021 but the labour data had not been too supportive. It was only in September 2021 that the first indications came that the era of transitory low inflation was over and unemployment was in check. Even at that point, the dot plot chart showed members betting on rate hikes in late 2022 and taper in late 2023.
According to Waller, 2 data points delayed the rate hike decision. Had the job creation not fallen to a third of its estimates in August, the Fed may have given the first signal of rate hikes in September and commenced rate hikes from November. In August 2021, new jobs come in at a shocking 2.35 lakhs instead of the anticipated 7.50 lakh. Jobs dipped further to 1.94 lakhs in September 2021, which led the Fed to putting off the rate hike decision.
In fact, Fed had already announced the rate hike in November 2021, immediately after the October jobs reported added 5.31 lakh jobs. This was when the Fed moved its narrative from “Inflation is transitory” to “Substantial progress has been made”. Waller reminded that Fed could not start rate hikes without winding down the monthly fresh bond buying of $120 billion. That commenced in November 2021 and was completed as planned in March 2022.
Being data driven over opinion driven
According to Chris Waller, the FOMC being a consensus decision making body, was data driven rather than opinion driven. It is easy to be a prophet of the past, in the absence of a solid data commitment. Here are some key takeaways.
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