Faced with higher-than-expected inflation, Federal Reserve officials have spent the past couple of weeks outlining their plans to do something about it. That may not sound like much, but it’s already working: As it turns out, simply talking about reducing inflation can itself reduce inflation.
Specifically, Fed officials have indicated that they are likely to accelerate the winding down of their quantitative easing policy. Last week, testifying before Congress, Chair Jerome Powell made his clearest statement yet on the subject: “It is appropriate, I think, for us to discuss at our next meeting, which is in a couple of weeks, whether it will be appropriate to wrap up our purchases a few months earlier.” The Fed said it would start reducing the scale of asset purchases by $15 billion per month, which would bring QE down to approximately $0 per month by the middle of next year. Under an accelerated taper, purchases could slow down faster and end sooner.
During his testimony Powell also reiterated the widespread view that the relevant variable is the size of the Fed’s balance sheet, and that any purchases whatsoever still represent an easing of monetary conditions. Under this view, even an accelerated taper represents monetary policy getting looser until QE is finally finished.
Since the accelerated taper talk began in earnest last month, the dollar is up, crude oil is down, and five-year inflation breakevens are down. The talk itself, in other words, is both directly reducing the prices of commodities and exports — and reducing forward-looking expectations of inflation.
The whole idea that quantitative easing (which really just amounts to swapping one safe asset for another) has a large impact on the economy has always been a little bit puzzling. Former Fed Chair Ben Bernanke famously quipped that “The problem with QE is it works in practice but it doesn’t work in theory.” But other economists argue that it works perfectly well in theory because QE influences people’s beliefs. Not necessarily those of random people on the street — those of professional market participants, who pay very close attention to the actions of central banks.
But people with money on the line don’t just wait around for Open Market Committee statements. Especially in the era of transparency and forward guidance, they pay a lot of attention to things Fed officials say. So talking about an accelerated taper isn’t just idle chatter about a potential future slowdown in the pace of monetary stimulus; it’s a real-time intervention in global markets. And while some Fed actions may operate with Milton Friedman’s famous “long and variable lags,” the essence of contemporary financial markets is that they operate with almost no lag at all.
That doesn’t mean inflation is finished. To retain its credibility, the Fed still needs to issue an actual statement delivering on its chatter, then follow through. And depending on how conditions look a month from now — which in turn may depend on how the omicron variant behaves — even more aggressive action may be warranted.
The point, however, stands: Monetary tightening is fairly fast and easy to execute. Those looking for a mechanistic account of how central banks slow inflation miss this. If you’re looking for direct linkages between interest rates and inflation, then you have to imagine a scenario where the Fed raises rates high enough to throw enough people out of work to significantly reduce car commuting and thereby reduce oil prices.