Is the US monetary policy strategy on track?

15 May 2023 , 09:46 AM

For instance, in 2021, the economists had remonstrated that the Fed was being too slow in raising the Fed rates. When the rate hikes started in March 2022, the complaint once again was that the rate hikes were too quick and would cause a recession. Now, the markets are largely unconvinced about the logic of the US Fed sticking to its hawkish stance at a time when the GDP growth had slowed in Q1 and the banking crisis was going from bad to worse.

Is the US monetary policy on track?

That raises the key question; is the US monetary policy on track. That means; is the policy robust enough to achieve the goals it intended to achieve in the first place. Obviously, there are limitations to an academic debate, so the best person to answer this question is someone from the Fed itself. That is exactly the point that Governor Philip Jefferson of the US Fed addressed at the Hoover Institution, Stanford, on the topic of ‘How to Get Back on Track: A Policy Conference’.

Obviously, the topic itself is rather loaded and raises the debate that the monetary policy of the US was currently off track. That was a point made by Philip Jefferson, partly in jest, at the beginning of his speech. However, he also addressed more critical issues. One of the popular questions in monetary policy has been to control inflation without impacting growth. Here Jefferson has rightly pointed out that recent macroeconomic models do permit disinflation with no slowdown in economic growth. According to Jefferson, monetary policy is never right or wrong. It is just about doing what is necessary and what is expected of the US Fed. That would be the more practical way to look at Fed policy.

In this rather interesting speech, Jefferson dwells upon 4 key topics to partially respond to the debate raised. Firstly, there is a focus on the inflation scenario in the US. Secondly, there is focus on the incoming labour data. Thirdly, Jefferson has dwelt at length on the evolving banking crisis in the US. Lastly, he also speaks about practical monetary policy making in uncertain times.

Assessing the inflation situation in the US

Price stability using the rates instrument has been the core focus of central bank monetary policy for years and the Fed is no different. Jefferson believes that the current inflation is still too high if looked at in the context of the targeted inflation rate of 2%. The Fed normally considers the PCE (Personal consumption expenditures) inflation rather than the CPI inflation since the former has more practical value from a policy standpoint. According to Jefferson, the PCE inflation is still high at 4.2% with core PCE inflation at 4.6%. Jefferson has specifically pointed out that much of the fall in inflation in the US is accounted for by falling food and energy prices. However, core inflation (ex-food and energy) continues to remain elevated. In short, there has been little progress on core inflation.

According to Jefferson, monetary policy must focus on the drivers of core inflation, which is what the Fed has been doing. While core goods inflation is coming down, recent data flows point to a possible bounce. In fact, outside of used motor vehicle prices, which fell in March, disinflation in core goods prices is happening at a much slower pace than expected. That is because; the supply and demand imbalances in the core goods sector were resolving less quickly than expected. Also, core services are still too sticky. In short, according to Jefferson, forget the headline inflation, the real story lies in core PCE inflation and that is still well above the inflation target rate.

Labour markets and GDP growth

According to Jefferson, even the latest labour data as of April 2023 pointed to strong labour markets. More importantly, the wage growth has continued to run ahead of the pace consistent with 2% inflation and trends in productivity growth. He adds that wage gains are welcome as long as they are consistent with price stability; not when they are triggered by excess demand. 

GDP growth in Q1 was down to 1.1% and this lower growth was despite strong growth in consumption. That was because inventory investment slowed down substantially, which was the key factor resulting in lower GDP growth in the March 2023 quarter. He expects slower consumer spending growth for the remaining part of 2023 due to tight financial conditions, depressed consumer sentiment, banking sector uncertainty, and declines in overall household wealth and excess savings. In fact, the banking crisis is automatically tightening credit in the US markets.

Evolving stress in the US Banking Sector

Over the last 3 months several big banks like Silicon Valley Bank, Signature Bank and First Republic Bank failed in the US and had to be bailed out. It was triggered by a liquid crisis caused by a combination of a run on deposits and bond losses amidst rising bond yields. According to Jefferson, this situation is ironically likely to supplement the efforts of monetary policy. Banks have already tightened credit to the consumers and that is showing on pressure on consumption. 

According to Jefferson, it would be reasonable to assume that recent stress events would lead mid-sized banks to tighten credit standards further. These credit restraints, combined with the need for more liquidity would result in lesser credit disbursal to consumers. The impact may not be substantial but it is likely to impact the incremental demand caused by easy credit. That is likely to reverse in the coming months. However, Jefferson is quick to add that such tight credit conditions have already made consumers wary of debt and they are already tightening their belts. To that extent the impact of the credit shock will be more.

Practical policy making in an uncertain environment

Jefferson adds that the post pandemic situation not only changed the structure of the US economy but also changed global supply chains substantially. At a time when the underlying economic triggers are in a state of flux, policy making becomes a lot more complicated. That is why Jefferson had mentioned right in the beginning that the Fed had to what was expected and necessary based on data. However, Jefferson has given some guidelines for monetary policy making in the post pandemic world.

• Policymakers must be ready and willing to react to a wide range of economic combinations of inflation, unemployment, growth, and financial stability. 

   

• Jefferson feels that in the post pandemic era, it is very important to communicate the intent and content of monetary policy to the public. For the Fed, anchoring longer-term inflation expectations continues to be a guiding light.

   

• Monetary policy today cannot get wedded to one approach and must be data-driven, yet willing to look at new data sets. Not just data points, even perspectives should be open to change over time.

Back to the core question on monetary policy track

That takes us back to the core question of whether US monetary policy is on track? Jefferson answers this question in two points. Firstly, monetary policy should be judged by the lens of whether it is doing what is necessary and expected. Secondly, Jefferson has also underlined that monetary policy impacts the economy and inflation with long and varied lags, so markets and economists must be prepared to wait to see the results. As Jefferson answers the question rather cryptically, “With great humility, I believe that the Fed is well on track. That should be good news for the US economy and obviously for the global economy too.