![]() Gagnon said Fed Chair Jerome Powell Fed needs to be nimble, but need not rush. In particular, if the Fed is raising rates above 2 percent then it may be appropriate, if inflation comes down quickly, to reverse those increases rapidly and…it’s important for the Fed to explicitly signal that that may happen.” And I think we may be at a moment where the appropriate policy is for the Fed to rapidly raise rates but make it very clear to markets that those rates might be reversed. “One thing that may be holding the Fed back…is a perception that it’s very costly to reverse course….It’s not a law of nature that when the Fed changes interest rates that’s going to stick for many, many years…. “Before you conclude that I’m crazy, you should reflect on the notion that if the core CPI inflation rate is at 6 percent, is it really so crazy to have a federal funds rate of 2 percent by July?” What the Fed should do after that depends on incoming data, he said. ![]() ![]() Steinsson recommended that the Fed should raise short-term interest rates by half a percentage point at each of the next four meetings of policymakers, which would bring the key federal funds interest rate (which has been at zero since March 2020) to 2 percent by July. And the net effect was that the demand shock would tend to push both prices and output up and the supply shock would tend to put prices up but output down.” The net result was that inflation was “way higher than anyone expected, even those of us who warned about inflation.” While he agreed with Steinsson that the Fed should have pivoted in November, Gagnon said a couple of months is not a big deal, and noted that the Fed has now signaled it will raise rates and markets anticipate that. “So we had two big supply shocks and one big demand shock. Gagnon said the Fed and other forecasters should have expected the $1.7 trillion CARES Act to boost aggregate demand substantially and push up inflation, but the supply shocks – the reluctance of workers to return to the job, for instance, and the remarkable surge in demand for goods versus services – were not foreseeable. Policymakers did change their message shortly after that meeting, but, Steinsson said, “by that time they were behind the curve and their remain behind the curve even today….The gap between what is appropriate right now and where they are is very large.” At their November 2021 meeting, Fed policymakers should have changed its forward-guidance language to suggest that it anticipated raising interest rates soon. “Being patient throughout most of last year given the developments that were hitting the economy at the time, the supply shocks and the shifts in demand from services to goods are both things that, I think, make sense to allow to at least temporarily raise inflation above the target.” But, he added, the Fed waited too long to pivot to a less accommodative stance. Steinsson said that Fed policy during 2021 “given what they knew at the time” was sensible. “When I was taught economics, I was taught that the reason you have independent central banks is to avoid a situation where short-sighted politicians….push as hard as they can on the employment side of their mandates….It’s not all clear to me how pushing as hard as you can on employment while pointing to inflation expectations being anchored as the justification is all that different from the inflation-bias scenario that the textbooks warn about.” ![]() “What the Fed said last year was, in effect, we’re not that worried about inflation because inflation expectations are anchored so we, therefore, think inflation will be transitory,” and thus monetary policy can focus on the other half of the Fed’s mandate, maximum employment. Incoming data, particularly wage growth, are inconsistent with the Fed’s 2 percent inflation target. (You can also watch a video of the conversation, moderated by the Hutchins Center’s Louise Sheiner.) Is the Fed behind the curve? The Hutchins Center put those questions and others to three experts on monetary policy at a March 2, 2022, event: Henry Curr, economics editor of The Economist Jon Steinsson, Chancellor’s Professor of Economics at the University of California, Berkeley, and co-director of the National Bureau of Economics Research’s monetary economics program and Joseph Gagnon, a senior fellow at the Peterson Institute for International Economic and a former senior Fed staffer. Did the Federal Reserve wait too long to raise interest rates to restrain inflation? Is the Fed’s new monetary policy framework working out as the Fed hoped it would? What are the biggest monetary policy challenges that the Fed faces in the next couple of years?
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