MNI: Fed's New Framework Tested By Inflation Surge

The Federal Reserve is facing tough questions about the viability of its new outcome-based approach to monetary policy less than a year after announcing the shift -- and before the new framework gets properly implemented, top former policymakers told MNI.

"Over the last six months to a year the strategy looks less and less credible, " said Charles Plosser, ex-president of the Philadelphia Fed. "It looks and less and less believable that they're not going to change their minds."

Post-Covid surges in inflation and growth have prompted debate within the Fed and in policymaking circles about whether the spikes are transitory, though the central bank promises to keep rates at zero until it has achieved its new price stability and full employment targets. These remain so loosely defined that there is wide discrepancy between market expectations for QE tapering later this year and the official determination to buy USD120 billion per month until "substantial further progress" toward the goals.

A jump in inflation to a much-larger-than-expected annual 4.2% in April seemed to be fueled by more than low base effect comparisons with last year's slump, Plosser said in an interview.

"The Fed has said it's not going to preemptively act, it's not going to act on the forecast, it's only going to act on actual inflation. Well, look at what they're doing -- they're basically acting on their forecast. Their forecast is that this is temporary but what if they're wrong?"

MOVING TARGETS

Former Richmond Fed president Jeffrey Lacker agreed.

"They've essentially said they will wait for a border crossing to occur before they react, which would seem to imply that a serious bout of inflation would do some damage before they manage to reverse it," he said, adding that the new framework is vulnerable to supply shocks, of which the pandemic is a "sizable" example.

"Fed officials are always going to say they can and will respond with sufficient force should inflation get out of control, but the boundary between transitory inflation surges and response-worthy upswings has been left vague."

Based on the experience of a sluggish and drawn out recovery from the Great Recession followed by low unemployment without inflation, the Fed last year said it would aim for a modest overshoot of its 2% inflation target and made its full employment mandate broader and more socially inclusive.

Since then, the economy has been bolstered by USD6 trillion in fiscal packages, which were nowhere on the radar during the framework revamp last August, prompting many investors and policymakers to reassess the outlook.

Meanwhile, even as April inflation jumped, payrolls disappointed at 266,000 new jobs.

"They've now adopted a monetary policy strategy that's untenable over time," said Andrew Levin, former Fed board economist and ex-special adviser to Treasury Secretary Janet Yellen when she was Fed chief. "When inflation tends to pick up speed real wages lag behind, so the scenario where the Fed would let inflation go up to 3% or 4% would be unpopular on a wide basis."

Levin thinks Fed's reaction function is becoming obfuscated and discretionary rather than transparent. "If we get four million more jobs in the next seven months -- what are they going to do? It's not clear."

RISK OF ABOUT-FACE

Even those who see high inflation or a major Fed policy error as low probability acknowledge the risk of an awkward about-face on how long policy can stay ultra-easy.

"Their new framework was built to handle the situation of the past 20 years, in which inflation was low and for many of those years below the 2% target and in which interest rates were persistently low, in part because inflation was low but also because equilibrium rates or r-star were low and declining," former Fed Vice Chair Don Kohn told MNI, referring to the so-called neutral rate of interest.

"A nice question is whether fiscal policy reverses some of that decline in r-star."

Former Fed Board economist Bill Nelson, who wants QE wound down, told MNI: "Saying we'll just wait and let the economy run hot and make sure there's as little damage as possible to the labor market -- that's heartfelt and made a certain amount of sense in certain circumstances, but they ended up making commitments that weren't resilient to a range of outcomes," such as one in which core CPI surges 0.9% in a month, the most since 1982.

"It's particularly striking that even just now this first brush with inflation appears to make them a little bit unsure that they're doing the right thing."