The Fed explains why it may have acted too slowly on inflation

Some Federal Reserve officials have begun to acknowledge that they were too slow to react to rapid inflation last year, a lag that forces them to constrain the economy more sharply now – and one that could hold lessons for the political path ahead.

Inflation started accelerating last spring, but Fed policymakers and most private sector forecasters initially thought price gains would quickly fade. It became clear in the early fall that rapid inflation was proving more durable, but the Fed did not decide to quickly remove policy support until late November and did not raise rates until March. .

Several current and former Fed officials have suggested in recent days that, in retrospect, the central bank should have reacted more quickly and more forcefully last fall, but that the deep uncertainty about the future and approach of the Fed to define its policy have slowed it down.

Officials had spent years dealing with tepid inflation, which made some reluctant to believe the rapid rise in prices would last. Even when they grew more concerned, it took time for the large group of Fed policymakers to come to an agreement on how to react. Another complicating factor was that the Fed had made clear promises to the markets on how it would remove support for the economy, which made it harder to adjust quickly.

“It was a complicated situation with little precedent — people make mistakes,” Randal K. Quarles, who served as the Fed’s vice chairman for oversight in 2021, said at a conference last week.

Mr Quarles, who left the Fed at the end of the year, argued that it should have started to withdraw support aggressively after September. He added, however, that the rate hikes that central bankers were currently making could still fix the situation.

Even so, the delay could have consequences. By the time the Fed stopped buying bonds altogether and started raising rates in March, prices had risen 8.5% from a year earlier, the fastest rate since 1981. The rises consumer prices are expected to remain brisk when new data comes out on Wednesday.

And as high prices have persisted, inflation expectations have risen, threatening to alter the behavior of households and businesses in ways that perpetuate the problem.

Because inflation eats away at paychecks and makes it harder for families to pay for groceries and cars, it has become a major political issue for President Biden, whose approval ratings have plummeted due to concerns regarding its management of the economy. During remarks at the White House on Tuesday, Mr Biden called inflation a “top national priority” and said his administration was taking steps to contain it. He also sought to fend off Republicans, who have spent months blaming him for stoking inflation, saying their policies were “extreme” and would hurt working families.

“I want every American to know that I take inflation very seriously,” Biden said, noting that the Fed has the “primary role” in trying to rein in price rises.

The Fed is now raising rates quickly to regain control of the situation. Officials raised borrowing costs by half a percentage point this month, their biggest increase since 2000, while signaling that two other major adjustments could be coming. They will also begin to reduce their bond balance sheet by $9 trillion next month.

If the Fed continues to adjust policy quickly this year as it tries to catch up, policymakers risk putting the brakes on a booming economy. Such abrupt stops can hurt, drive up unemployment and possibly trigger a recession. Officials generally prefer to apply their political brakes gradually, increasing the chances that the economy can slow down painlessly.

Still, several Fed officials pointed out that it’s easier to say what the Fed should have done in 2021 after the fact — that right now it’s hard to know the price hikes will last. Inflation initially came mainly from a few large commodities that were in short supply amid supply chain issues, such as semiconductors and cars. It wasn’t until later in the year that it became clear that price pressures extended to food, rents and other areas.

“I try to give a little grace and say: in a very uncertain time, with an unprecedented framework, without real role models to guide us, people are going to do the best they can”, Raphael Bostic, president of the Federal Reserve Bank of Atlanta, said Monday in an interview. Mr. Bostic was one of the first to suggest that the Fed should stop buying bonds and think about raising interest rates.

Officials said it was the acceleration in inflation data in September, followed by rising employment costs, that convinced them the price gains could last and that the central bank should act to decisive way. Fed Chairman Jerome H. Powell changed policy in late November as these data points added up.

While Mr. Quarles argued that the Fed should have reacted when the September data came in, he suggested there had been a complicating factor: Mr. Powell was waiting to see if he would be reappointed by the Biden administration, which did not announce its decision to reappoint him until mid-November.

Mr Quarles, in a “Banking With Interest” podcast episode last week, said it was “difficult to react to the data until there was clarity on what the leadership of the Fed would be. in the future”.

Moreover, the Fed had promised to withdraw policy in some way, which prevented a quick reorientation once officials began to worry that inflation might last. Policymakers had pledged to keep interest rates low and to continue buying huge amounts of bonds until the labor market recovered significantly. They had also made clear how they would remove support when the time came: bond buying would first slow, then stop, and only then would rates rise.

The goal was to convince investors that the Fed wouldn’t stop helping the economy too soon and avoid rattling the markets, but this so-called forward guidance meant that the withdrawal of support was a process of lengthy.

“Foresight, like everything in the economy, has benefits and costs,” said Richard H. Clarida, who was vice chairman of the Fed in 2021 and recently left the central bank, during a conference last week. “If there are directions that the committee feels obligated to honor,” he added, it can be complicated for the Fed to go through a sequence of policy measures.

Fed Governor Christopher Waller noted that the central bank is not standing still. Markets have started to adjust as the Fed accelerated its plans to cut policy support through the fall, making money more expensive to borrow and starting to slow economic conditions. Mortgage rates, a window into how Fed policy affects the economy, started rising notably in January 2021 and are now at the highest level since the 2008 housing crisis.

Mr. Waller also pointed out that it was difficult to get a quick agreement from the large policy-making committee of the Fed.

“Policy is set by a large committee of 12 voting members and a total of 19 participants in our discussions,” he said during a speech last week. “This process can lead to more gradual policy changes, as members have to compromise to reach consensus.”

Loretta Mester, president of the Federal Reserve Bank of Cleveland, said in an interview Tuesday that different people on the committee “looked at the same data with different goals, and that’s just the nature of the beast.”

But the Fed seems to be learning from its 2021 experience.

Policymakers avoid giving clear guidance on what’s next on policy: Officials have said they want to raise rates quickly to the point where they start to weigh on the economy, and then go from there. While Powell said the Fed was considering half-point increases at its next two meetings, he gave no clear indication of what would follow.

“It’s a very difficult environment trying to give forward guidance, 60, 90 days ahead – there’s so much that can happen in the economy and in the world,” Mr Powell said. at a press conference last week. “So we’re giving ourselves space to look at the data and make a decision as we go along.”

The war in Ukraine is the latest surprise that is changing the outlook for the economy and inflation in ways that are hard to predict, Bostic of Atlanta said.

“I was humbled, chastised – whatever – to think that I know the range of possible things that can happen in the future,” he said. “I really tried not to lean into one type of story or path.”

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