The Fed Tries to Get Out in Front
The most recent projections for growth, inflation, and interest rates "under appropriate monetary policy" may give the central bank more room for downside surprises, or even to adjust rates lower.
I recently had the pleasure of joining Chris Hayes to discuss inflation—and everything else in the economy—on Why Is This Happening? I encourage you to have a listen, or at least read the transcript.
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Having been burned by recent experience, Fed officials may have finally overcorrected from being excessively optimistic about the economy’s post-pandemic prospects to being unreasonably pessimistic about the growth/inflation tradeoff. If so, there may be room for an adjustment in the months ahead. While it’s clear that America’s monetary policymakers are willing to push the U.S. economy into a downturn if they deem it necessary, the interesting question is: how might they respond to a situation where inflation comes in slower than current projections?
The Evolution of What to Expect “Under Appropriate Monetary Policy”
Back in September 2020, Federal Reserve officials believed that the downturn attributable to the pandemic would be extremely deep and that the subsequent recovery would be relatively modest. Even “under appropriate monetary policy”, officials believed that Americans would be producing 2.5% fewer goods and services at the end of 2022 compared to what had been expected before the pandemic. The jobless rate was expected to remain above the pre-pandemic level until at least 2024.
Optimism about vaccines, productivity gains, and constructive fiscal policy from a unified U.S. government led to a complete revision of the forecast over the following months. By June 2021, Fed officials believed that American workers and businesses would be producing almost 3% more goods and services at the end of 2023 compared to the pre-pandemic forecast. There wouldn’t even be a cost to be paid in the form of permanently higher prices relative to what had been expected in December 2019, in part because Fed officials believed that joblessness would come down only slowly. “Under appropriate monetary policy”, short-term interest rates would only start rising near the end of 2023.
Things look different now. Fed officials’ latest projections are more pessimistic than the ones from before we got the good news about mRNA vaccines. “Under appropriate monetary policy”, Americans can now expect to be 3% poorer at the end of 2023 compared to what had been projected before the pandemic—and to remain permanently worse off in the years after that. Compared to the June 2021 projections, the level of real gross domestic product at the end of 2023 has been marked down by 5.5%. That’s worse than the hit from the pandemic itself!
While some of the growth hit may be attributable to supply constraints caused by Russia’s war on Ukraine and the persistence of the coronavirus, Fed officials believe they also have a role to play, with short-term interest rates currently expected to rise from 0% at the start of this year to somewhere above 4% by December. At least a few officials likely believe that short rates will need to go above 5% in the first half of 2023 “under appropriate monetary policy”.
Unsurprisingly, policymakers now expect the jobless rate to rise sharply, from 3.5% in July 2022 to at least 4.4% before the end of 2023. Fed Chairman Jerome Powell noted at the post-meeting press conference that the targeted growth path “could give rise to higher unemployment.” While Powell denied that anyone at the Fed wanted workers to lose their jobs, he was clear that “we need to have” a sharp slowdown in growth—and that Fed officials would accept a lot of economic “pain” if it meant bringing inflation back in line.
In practice, it is difficult to imagine unemployment rising that much that quickly without rising even further. There is simply no precedent for a sharp but contained uptick in joblessness that simply stops. Former Fed economist Claudia Sahm has noted that every single U.S. downturn has been accompanied by an increase in the jobless rate of at least 0.5 percentage point within 12 months. Most Fed officials currently expect to start lowering interest rates relatively quickly after peaking in mid-2023, but that probably wouldn’t be enough to get us out of a downturn if we were already in one.