Fed’s Latest Shift Still Consistent With Policy FrameworkBy Tiffany Wilding
At its June 2021 meeting, the Federal Open Market Committee (FOMC) indicated it was discussing options for tapering bond purchases and revised higher its forecast for the path of interest rates. Since then, many investors have been raising questions about the Federal Reserve’s commitment to the new monetary policy framework it introduced in August 2020, which included allowing inflation to overshoot target levels at times.
We believe FOMC participants’ views are still consistent with the August framework. Indeed, the recent increase in longer-term inflation expectations implies less need for above-target inflation in 2023 and beyond.
Nonetheless, these expectations have adapted more quickly than many observers anticipated to the recent bout of higher inflation, suggesting that expectations may also react should inflation turn out to be transitory. As a result, we believe some shift in the Fed’s outlook for monetary policy was and is warranted; however, we would caution against reacting too forcefully to these recent developments.
In this Q&A, economist Tiffany Wilding discusses PIMCO’s views on some key questions, and the implications for monetary policy.
Q: What were the key developments at the June FOMC meeting?
A: First, Chairman Jerome Powell said the FOMC started to discuss options for ending the Fed’s bond-purchase program. This was expected.
Second, the Summary of Economic Projections (SEP) revealed that at least 12 of the 17 FOMC participants revised higher their rate-path forecasts, pushing the 2023 median up 50 basis points (bps). This shift was larger than expected, and importantly, it coincided with only small revisions to the 2023 unemployment rate and inflation forecasts, suggesting the Fed is no longer aiming for some above-target inflation in 2023 and beyond.
Q: If inflation is transitory, why did officials’ views on the timing of rate hikes change so dramatically?
A: Some commentators have suggested that the SEP changes raise questions about the Federal Reserve’s commitment to the new “average inflation targeting” monetary policy framework, while others have asserted that FOMC members haven’t dismissed the strategy, but rather are implementing it using a relatively short inflation averaging period. Indeed, the gap between the 2% target and annual average inflation (based on core PCE inflation, the Fed’s preferred measure) is 0.2 to 0.3 percentage point over the past 10- or 20-year periods (i.e., inflation has averaged below the Fed’s target), but is appreciably smaller over shorter periods: 0.1 percentage point during the past five years and zero (i.e., the Fed has hit its target) over the past three years.
We think neither assertion is quite right. Although we agree that the recent above-target inflation reduces the need to “make up” for below-target inflation, these arguments miss a key element for the Fed’s new strategy: the importance of inflation expectations.
In the simplest terms, the Fed implemented its new strategy with the purpose of re-anchoring inflation expectations. The idea of allowing an inflation overshoot to atone for past undershoots was based on the observation that longer-term expectations appeared to be drifting lower as a direct result of the prolonged period of below-target inflation after the 2008 global financial crisis (see our recent blog post, “Realigning Inflation Expectations ”).
Since there was a good deal of uncertainty around how quickly longer-term inflation expectations would adapt to new trends in actual inflation, the FOMC was intentionally vague about how much above-target inflation it would tolerate and for how long.
Behavioral economists suggest that inflation expectations are formed over a lifetime and as a result are sticky for older people, whereas the young adapt more quickly. Consistent with this, we’ve previously found trailing averages of realized inflation follow longer-term inflation expectations closely.
However, over the past few months, longer-term expectations have risen quickly, despite the transitory nature of the current bout of inflation. For example, the Fed’s Common Inflation Expectations Index (CIE) has rebounded back to the middle of its historical range (see chart). As a result, the Fed no longer needs above-target inflation in the medium term.
Q: Are there broader implications of more adaptive inflation expectations?
A: Yes. Because longer-term inflation expectations have adapted higher relatively quickly to the recent bout of inflation, it’s now also more likely that they will just as quickly shift lower should inflation turn out to be transitory, as we expect.
More broadly, monetary policy that is set to manage inflation expectations that adapt relatively quickly to actual trends in inflation is going to be more volatile than policy set under a scenario where expectations are sticky.
Q: Did the June meeting change PIMCO’s outlook for monetary policy?
A: Not really. Prior to June, we expected the first Fed rate hike to be announced sometime in the second half of 2023 (see our recent Cyclical Outlook, “Inflation Inflection” ). The SEP revisions imply Fed officials are now more aligned with our view.
However, FOMC participants’ rate-path revisions did increase the risk that bond-purchase tapering will be announced in September, in our view. There are now seven participants who believe it will be appropriate to begin raising rates in 2022, and they would likely prefer the FOMC to announce tapering sooner, and implement it faster, than our current forecast for tapering to be announced at the December FOMC meeting, begin in January, and last through August 2022.
Q: What if inflation remains persistently high before the labor market is back to pre-pandemic levels?
A: In this scenario the Fed would likely revise its estimate of maximum employment and raise rates.
In arguing for ultra-easy monetary conditions, Chair Powell has recently emphasized that the level of employment remains well below where it was pre-pandemic. However, the broader FOMC has never officially set a numeric employment target, because maximum employment is not directly measurable and changes over time owing largely to nonmonetary factors, including changing demographics, the education of the labor force, labor market frictions, and technological change.
It’s highly uncertain how much the pandemic affected the level of maximum employment. For example, it may have declined due to the higher rates of retirement spurred by the pandemic, or higher rates of long-term disability resulting from lasting COVID symptoms. On the other hand, federal government policies focused on bringing workers – and women in particular – into the labor market, including childcare tax credits, could improve prime working age participation over time.
Q: What is the most likely exit sequencing from accommodative monetary policy?
A: During the last cycle, the Fed normalized policy by first reducing, and then ceasing, monthly purchases of Treasuries and agency mortgage-backed securities (MBS), while continuing to reinvest the proceeds of maturing securities. Then it raised rates, and finally when rates were just over 1%, it began to reduce the size of its balance sheet, by ceasing reinvestments in a gradual, predictable manner.
Because the last policy-normalization sequencing was largely viewed as successful, we suspect the Fed will use it again.
Q: Would the Fed raise rates before tapering ends?
A: This is unlikely, in our view. Due to worries that inflation will necessitate a much faster exit from highly accommodative monetary policy, some have suggested that the Fed could raise rates before it ends the Treasury and MBS purchase programs. We are skeptical of this policy for a few reasons:
- Raising rates before ceasing purchases reduces the effectiveness of quantitative easing (QE) as a tool to ease when the federal funds rate is at the effective lower bound. The asset-purchase programs ease financial conditions, in large part due to their ability to anchor rate expectations. This feature hinges critically on the market’s perception that the central bank will stop purchases before raising rates.
- It’s hard to credibly argue that deviating from a framework of being regular and predictable will be less disruptive for bond markets. If the Fed continued to expand the balance sheet while hiking, it would have to hike more than otherwise to offset the continued balance-sheet accommodation. The faster rate hikes would be a surprise to the bond market, and the repricing of rate expectations could be as disruptive (if not more) than if the Fed abruptly ended the purchases.
- Assuming the Fed could manage the reaction of long-term rates by continuing bond purchases, it’s not obvious that the Fed could control tightening financial conditions, though the currency and foreign exchange markets can also overshoot.
Taking a step back, if inflation necessitates a larger and faster shift toward tighter monetary policy, a necessary condition to effectuating this policy is disrupting the bond market. Central bankers (and market participants) are going to have to get comfortable with that uncomfortable fact.
Visit PIMCO’s inflation page for further insights into the inflation outlook and investment implications.
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