Did the US Fed fall behind the curve in hiking interest rates?

9 May 2022 , 12:26 PM

The US Fed has kept its word about hiking rates and being aggressive about the rate trajectory. In its monetary policy statement after the May 2022 FOMC policy, the Fed not only announced a 50 bps rate hike, but also promised to boost rates by another 175-200 bps by the end of 2022. However, this has opened up two separate debates.

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.

1. Firstly, the Fed itself has a dual mandate from the government. On the one hand, they have to maintain price stability but they are also required to ensure maximum jobs. Normally, 5% unemployment is defined as full employment and this has now fallen to 3.6% only because fewer people are looking for a job. According to Waller, in these contrasting targets, the Fed at times is forced to err on the side of caution, which is what the Fed actually did in 2021.
2. The second point made by Waller is that the Fed policy is not just a Federal mandate. It is set by a committee of 12 voting members with 19 participants. This is done to ensure that the state Federal Reserves also get representation. Due to the need for a broad consensus, the moves by the Fed are more calibrated. This is a practical challenge that most policy making models have to live with.

Waller’s contention is that the need for balancing jobs and price control as well as the need to balance the interest of all regions results in more cautious decision making.

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.

• It is not just the government view on the post-pandemic growth, but even the private sector was guilty of underestimating the magnitude and depth of inflation. The demand supply gap was not expected to become as virulent as it actually became.
• There were 2 extraneous events. The Ukraine war and the China lockdowns had the potential to slow US growth and disrupt global supply chains. That is why the Fed took time till March 2022 to hike rates. Waller pointed that, the delayed rate hike by the Fed still risks monetary divergence. That is the risk of setting policy in real time.
• While actual rate hikes started in March 2022, the process had begun in the last quarter of 2021 itself. That was when, the first guidance of rate hikes and the fresh bond purchases unwinding were given. Markets are the best barometer and the 2 year treasuries had risen from 25 bps to 75 bps by December; even as the 10-year benchmark had shot up sharply. The cost of funds had spiked, long before the actual rate hike.

It must be said that an economy of the size and complexity as the US, the FOMC has moved with amazing alacrity and flexibility. A lot will depend on whether this really slows growth?