The Federal Reserve’s new course is good

At the conclusion of this month’s meeting of Federal Reserve policy makers, the central bank announced that it will “soon be appropriate” to start raising interest rates. This affirmed investors’ expectations of a first quarter-point increase in March followed by two or three more before the end of the year. In addition, the Fed says it will end its net asset purchases — so-called quantitative easing — in about a month and is considering how quickly after that to reverse the process and run its balance sheet down.
None of this was surprising. The Fed has been foreshadowing it
for weeks. Yet financial markets greeted the announcement
nervously. How come?
The problem is that the Fed’s new policy is still a long way from normal for an economy running at or above full capacity. Remember that higher prices have delivered a strong unintended stimulus in recent months by making real interest rates even more negative. After the adjustments in March, monetary policy will still be substantially looser, not tighter, than it was a year ago.
Investors know that if higher inflation persists, getting it back under control will take a lot more than a few quarter-point rises in rates and a tentative shift to quantitative tightening. But a more forceful throttling of monetary policy threatens a collapse in asset prices and serious collateral damage to the economy. This is the risk that investors are trying to price and the Fed is struggling to manage.
For the moment, despite the dangers, the central bank’s approach looks right. Yes, the rise in inflation has been bigger and more persistent than the Fed’s officials (and most everybody else) expected last year — but some of the rise is still likely to prove transitory as the pandemic subsides. Given this continuing uncertainty, the Fed would be wrong to abruptly reset policy as though the current rate of inflation is entrenched, ignoring the risk to the recovery.
It’d be wiser to do what Powell has now done: Recognize that demand is running too high. Admit that inflation is worse than expected, and that some of the overshoot might persist. Rein in the current accommodation without limiting the central bank’s room for maneuver. Watch the data with an open mind. And be ready to loosen policy if demand should suffer a new setback — and tighten more forcefully if inflation doesn’t soon subside.

—Bloomberg