MNI: Fed Framework Creates Room to Wait On 2022 Hikes

The Federal Reserve is beginning to tone down its emphasis on its newly-inclusive jobs goal as a surge in prices proves less transitory than expected, but an ambiguous year-old inflation-targeting strategy allows the FOMC an unprecedented degree of flexibility as to when to raise interest rates, former Fed officials told MNI.

The monetary policy framework inaugurated in August 2020 was designed with the idea of fighting demand shocks and low inflation with rates constrained by the zero bound for years to come. Instead, a pandemic-driven supply shock has pushed inflation uncomfortably high and created a conflict between price stability and full employment objectives.

"The Fed has never been very specific about how it weighs those two objectives and that creates a lot of uncertainty about the direction of policy," former Dallas Fed principal monetary policy adviser Evan Koenig said.

VAGUE GOALS

The FOMC's most recent dot plot shows half of its 18 members expect to lift rates from zero in 2022. But complicating the debate over when to hike is the lack of agreement among officials over what period of time the Fed seeks to have inflation average 2%, and whether it's even possible to attain full employment across social groups with a single monetary policy.

This unstated time horizon "gives the Fed a fair amount of flexibility," said former Fed Board economist Jaime Marquez. Other ex-officials said the Fed could tolerate 3% inflation for some while if officials were confident that it would settle toward target, because of their commitment to getting employment back to pre-Covid conditions.

"Under the old framework, they would have had to raise rates now. But that would have had an effect on the economy that in my mind would go against full employment," Marquez said, "By having this new approach, the Fed is trying to interact with the market in a way that's not rigid, that's not mechanistic."

And even if there's a limit to the labor market benefits low rates can bring about, "it doesn't mean they don't try," he said.

CHANGE IN EMPHASIS

Thus far officials have emphasized the employment side of the mandate, resting on the argument that elevated inflation will pass, but that has started to reverse as it's become increasingly clear that prices will keep rising well into next year.

"If by mid-year next year inflation isn't behaving as expected and the transitory view hasn't borne out, and, at the same time, we've seen at least modest continuing improvement in the employment picture, then the liftoff decision could come sooner than would otherwise have happened," former Atlanta Fed President Dennis Lockhart told MNI.

"The committee might communicate the change of emphasis by saying: While still fully committed to achieving the best possible employment conditions, the committee recognizes, looking ahead to 2023, that inflation risks continue to be elevated and feels a response is required to address continuing inflationary pressures," Lockhart said.

The Fed's statement of longer run goals says that when its two goals are in tension, it will take into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with the mandate.

In other words, the Fed is increasingly compelled to bring inflation down to its target level by raising rates to dampen the pace of economic activity the greater the Covid-related supply shock and the longer it persists, the former officials said.

FRAMEWORK ALREADY OUT OF DATE?

The Fed re-ups its framework annually, though the recent revamp was years in the making. Some who believe the Fed is behind the curve urge a fundamental rewrite sooner.

The framework contains "a commitment to letting inflation run hot before doing anything about it, but silence about what the Fed might do if inflation really breaks out," John Cochrane of Stanford University, a member of the New York Fed's Financial Advisory Roundtable, told MNI.

""If the Fed has to contain a spiraling inflation, it will need to convince people that it has the will and ability to sharply raise interest rates and keep them there until the job is done. That will require a completely new framework," Cochrane said.