Mistakes Were Made
The Fed thought they achieved the immaculate disinflation / “Golden Path” last fall and figured they could pivot policy in a more dovish direction and never deliver the last intended rate hike that a substantial majority of Fed members had expected in September 2023. They began to pat themselves on the back and figured it would be better to make sure the economy ran hot throughout 2024 and into the election as the economy didn’t need more “pain” to return inflation to target. But as it turned out, they were wrong.
They pivoted too soon as they failed to realize that in a highly financialized economy, the loosening of financial conditions has drastic and immediate implications on actual economic activity, inflation expectations and inflation. The lags are not simply long and variable. Markets move in real time and impact human behavior immediately.
The Fed’s myopia for real rate normalization cuts rather than a holistic view about financial conditions blinded them (the stupid Williams r* model led them astray) and now the economy is paying the price for the Fed’s mistake. They need to tighten financial conditions again now in order to get us back on a path to 2% inflation. They must actually bring down demand further because supply side improvements are largely over. That could be done by introducing dual sided risk to their policy where the next move could be either a rate hike or a cut rather than the asymmetry we have now where the bar to cut is much lower than bar to hike.
While Powell walked back the idea of a hike at the May meeting, he doesn’t speak for the entire committee and if we get another strong inflation print next week, the Fed should lean into that and remove more of the interest rate cuts from the Dot Plot at the June meeting.
They decision to begin tapering QT seems misguided and confusing at this point as it sends mixed signals about their intentions. They have set up facilities like the SRF and the discount window already if liquidity is eventually needed but for now, clearly liquidity is significantly more than ample. While this ship on tapering has sailed for now, hopefully future Fed meetings talk about the need for actual MBS sales (rather than rolloffs) as a way to keep reducing the balance sheet faster since they haven’t been hitting their target on MBS reduction at all since the tightening began.
Policymakers should stop putting out fires before they start if they expect to achieve their intended goals on a sustainable basis. The Fed should take its medicine today, re-introduce rates volatility, dampen animal spirits, re-anchor inflation expectations and bring down actual inflation thru a tightening of financial conditions that leads to a reduction in asset prices which hits the wealth channel. If done properly, it can probably be done in a way that is not overly destructive to the labor market and economy. When mistakes are made, you admit them and then course correct. This is the way.
