Don’t expect much from this week’s Federal Reserve policy meeting—or any meeting for the rest of this year, at least.
America’s monetary-policy makers are comfortable with where they’ve put interest rates and have deliberately set a high bar for making any adjustments. As they said in December, there won’t be any changes to interest rates “until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.”
While each of those three conditions is somewhat ambiguous, the combination should prevent the Fed from repeating the mistakes made after 2008. After the financial crisis, the Fed—and many others—kept expecting the economy to recover faster than it actually did, prematurely withdrawing support in 2009, 2011, 2013, 2015, and 2018.
By 2019, however, Fed officials had learned from their experiences. That’s why they lowered interest rates that summer as a “mid-cycle adjustment” to avoid a downturn that hadn’t happened yet, and it’s also why they launched their “framework review” that same year.
One of the big conclusions from that review was that the central bank had an unfortunate habit of assuming that, past a certain point, a drop in the jobless rate was bad and needed to be resisted. At the end of 2015, for example, Janet Yellen, who was then the boss, argued that the Fed should raise interest rates “to check the pace of employment growth.” According to her, the goal was to be pre-emptive at all costs, which was why she thought that “further moderate increases in the federal funds rate would probably be warranted, even if core inflation was still showing no signs of picking up.”
The Fed now seems determined to break that habit, with official documents explaining that a strong job market by itself isn’t a good reason to tighten policy. The basic reason is that inflation has tended to be pretty stable around its longer-term trend regardless of how well or badly the job market is doing. That raises the costs and lowers the benefits of tightening monetary policy pre-emptively—or, equivalently, it boosts the benefits and cuts the downside of waiting before trying to slow the economy.
Richard Clarida, the Fed’s current vice chairman, noted a few weeks ago that “declines in the unemployment rate [before the pandemic] occurred in tandem with a notable and, to me, welcome increase in real wages that was accompanied by an increase in labor’s share of national income, but not a surge in price inflation.” The new framework was informed by that experience and is therefore “asymmetric,” with more of a tilt to seeing just how low the unemployment rate can go. “Policy will not tighten solely because the unemployment rate has fallen below any particular econometric estimate,” Clarida said—unlike in the 2010s.
Lael Brainard, another influential Fed governor on monetary policy questions, has also emphasized this point, noting that “the conventional practice of reducing policy accommodation pre-emptively when unemployment nears its estimated longer-run normal rate is likely to lead to an unwarranted loss of opportunity for many workers.” That’s why the new approach rejects pre-emption and instead focuses only on “shortfalls from maximum employment.”
In other words, Fed officials really don’t want to start raising rates until after the job market recovers at least to where it was before the pandemic. The latest projections show that most Fed officials don’t think that will happen until the end of 2023 at the earliest. Even then, there could be further room to run. After all, the share of Americans age 25-54 with a job was about 1 percentage point higher in the late 1990s than it was on the eve of the pandemic.
The other big question is what happens with inflation. The Fed’s preferred measure has consistently run slower than the 2% yearly goal ever since the financial crisis—and the picture looks even worse after stripping out dubious categories such as “financial services furnished without payment” that generated massive imputed price increases. Officials had been trying to generate faster inflation before the pandemic to make up for some of the lost ground, but had failed to do so.
So far, the pandemic has led to a mild slowdown in overall consumer price inflation, with the cost of everything from rent to college tuition rising much more slowly than in the past, if not falling outright. Spikes in the prices of used cars and appliances haven’t been enough to offset this trend.
A return to normalcy with the vaccine could lead to large one-off shifts in relative prices, but that wouldn’t be the same thing as a sustained acceleration in the rate of inflation. Most Fed officials don’t even think inflation will exceed 2% by the end of 2023. “A lot of the movements in inflation are just noise,” explains Bill English, who was the top staff economist at the Fed before joining the faculty at the Yale School of Management.
Just as Fed officials have been trained to ignore one-off downturns in the price of oil or unlimited cellular data plans, they will also be cautious about overinterpreting movements in airfares or hotel room rates before concluding that inflation “is on track to moderately exceed 2 percent for some time.” They have been burned before, and since they believe the cost of waiting is low, they will probably try to err on the side of waiting too long to raise rates.
The new perspective explains why almost everyone at the Fed believes that short-term interest rates will still be around zero by the end of 2023 under “appropriate monetary policy”—even though they also expect that gross domestic product will have fully recovered from the pandemic and expect that the unemployment rate will be below 4%.
Whether it’s the right policy approach or not, it’s definitely a break from the past, and investors should remember it before betting on higher interest rates.
Write to Matthew C. Klein at [email protected]