reALMOST of the pandemic, exceptional uncertainty over the future of the US economy was overcome with exceptional certainty that monetary policy would remain very flexible. Not anymore. At the Federal Reserve’s meeting in June, policymakers signaled they could hike interest rates in 2023, sooner than they previously thought, and improved their inflation expectations for that year. Investors spent a week struggling to digest the news. Long-term bond yields, which move in the opposite direction to prices, first rose and then fell below their initial level. Stocks fell sharply and then rallied. Emerging market currencies, which are suffering from the tightening of US monetary policy, depreciated against the dollar.
The Fed’s future interest rate decisions can suddenly be counted among the many unknowns hanging over the economy as it recovers from the pandemic. Already on the list were the impact of new variants of the virus, the fate of President Joe Biden’s infrastructure plan, the rate at which consumers will spend the savings they accumulated during the crisis and the persistence of bottlenecks. that disrupt supply chains. and labor markets. When Fed policy seemed frozen, changing investor views on these puzzles was reflected directly in their expectations for growth and inflation. Now they also need to assess the possibility of the Fed stepping in to prevent overheating by raising rates earlier.
The Fed’s change of direction appears to have been prompted by the realization that inflation next year will be higher than expected. In the three months leading up to May, basic consumer prices, which exclude food and energy, rose at an annualized rate of 8.3%, the highest since Paul Volcker led the war on l inflation in the early 1980s. The central bank expects price pressures to ease quickly. They will nevertheless leave a mark on future monetary policy.
The Fed is aiming for average inflation of 2% over the entire economic cycle, and higher inflation today is already offsetting the drop in prices at the height of the crisis. The central bank expects its preferred price measure at the end of 2021 to be 3.4% higher than a year earlier, 0.6% higher than it would have been if inflation had been target since late 2019. Count from August 2020, when average inflation targeting has been introduced and the price overrun will be 1.2%.
The Fed’s change of tone is therefore welcome. Since inflation expectations can come true on their own, a public reminder that the Fed does not want the price spike to get out of hand reduces the chances of that happening. A gradual adjustment today also reduces the likelihood of a bond yield panic spike tomorrow, helping to avoid a “tantrum” like the one in 2013 after the Fed announced it would buy fewer bonds.
Jerome Powell, the chairman of the Fed, strikes the right balance between avoiding such a mistake and recognizing that the job of the central bank is to achieve its economic objectives, not to ensure the peace of the financial markets. He could do even better by clarifying the Fed’s frustrating average inflation target.
More worrying is the poor quality of the central bank’s forecasts. The Fed has given up for two years in a row, underestimating the employment rebound in 2020 and now being caught up by inflation. Other surprises are likely. The risk of higher inflation is particularly important. To be sure, the prices of some commodities, like copper, have fallen from their highs reached in May and have fallen further since the Fed met. But uncertainty in bond markets has increased, oil prices continue to rise, and many forecasters, including Fed officials, fear higher inflation may persist until 2022.
It has become clearer that monetary policy will react to higher inflation, as it should. But it does mean that interest rates – and therefore asset prices – will more reflect the uncertainty that is disrupting the economic outlook. ■
This article appeared in the Leaders section of the print edition under the title “New horizons”