Fed has more options than 0% interest rates

After the red-hot US consumer price index reading of 6.2%, debate around what the Federal Reserve should do about inflation has reached a fever pitch. There are two prevailing schools of thought: The Fed should do nothing. The Fed should speed up the pace at which it gradually tightens monetary policy.
Some of those who side with view No. 1 argue that taking path No. 2 would choke off the swift economic recovery and leave millions of Americans unemployed. This, in effect, assumes the world’s most powerful central bank has a binary decision between sitting on its hands or throwing the US into a downturn. That kind of framing seems misguided at best. Tim Duy, chief US economist at SGH Macro Advisors, put it this way: “It’s not a choice between a recession or zero rates forever.” Indeed, it’s time for the Fed to start contemplating how to tread a middle ground if officials continue to be wrong about inflation.
It’s true that as part of the central bank’s new framework, it pledged to leave interest rates near zero until the labour market reached “maximum employment.” But that’s an intentionally vague threshold that provides ample wiggle room and was created with the post-2008 economy in mind, when sustainable inflation was a mirage. The quits rate, wage growth and job openings all suggest a tight US labour market, and certainly one that wouldn’t suddenly crumble beneath a fed funds rate that’s 50 basis points higher.
In fact, a couple of interest-rate boosts from the Fed would still leave the central bank in a historically ultra-easy policy stance when considering the current pace of inflation. The fed funds rate adjusted for headline CPI is about -6%, the lowest on record. Longer-term US real yields remain near all-time lows as well. Measured this way, no previous Fed has ever been so willing to look through price pressures. There’s room to maneuver, yet a modestly accelerated tightening path — say, winding down monthly bond purchases by March and creating the option to raise interest rates quarterly, as St Louis Fed President James Bullard suggested — is seen as unconscionable.
The uncomfortable truth for Chair Jerome Powell, who clearly wants to be dovish, is that the increase in inflation and expectations for future price growth is exactly what he said he was hoping for when unveiling the new framework in August. The reason he wanted to push those upward? So the Fed would have the scope to raise interest rates. By central bankers’ own estimates, the “neutral” fed funds rate that’s neither accommodative nor restrictive is 2.5%. That’s a long way from zero.
Those who say the Fed should do nothing argue that inflation will ultimately prove to be transitory, even though policy makers have been way off in their forecasts for price pressures this year. In March, the median estimate for inflation as measured by the personal consumption expenditures index was 2.4% for this year. That was raised to 3.4% by June and 4.2% by September. By contrast, the median for 2022 has only increased to 2.2% from 2%. Central bankers are holding out hope that they’ll be right — if they’re not, as they haven’t been in recent months, they will probably only adjust expectations when their backs are against the wall.
“We need to take it very seriously, but my view is we also need to not overreact to some of these temporary factors even though the pain is real,” Minneapolis Fed President Neel Kashkari said on CBS’s “Face the Nation” about the pickup in inflation.
Again, this feels like a strawman. Few are arguing for anything that would constitute an overreaction. Even those who lean hawkish, like former New York Fed President William Dudley and former Richmond Fed President Jeffrey Lacker, aren’t pushing for a Paul Volcker-like approach to combat inflation by shocking markets and jacking up interest rates.

—Bloomberg