Fed: If Not Now, When?

Fed Chairman Powell insists it would be premature to tighten monetary policy. But if not now, then when?

The consensus view argues that the Fed sits in a very comfortable position: the rise in inflation is most likely temporary; even if higher inflation persists, the Fed knows how to fight it, and at the end it will have finally exorcised the specter of deflation and stabilized both inflation and interest rates at healthier levels. Tightening monetary policy now would jeopardize the recovery for no good reason.

I think the Fed faces a much harder choice. And not because I see a high risk of runaway inflation forcing brutal interest rates hikes that would trigger a recession. Not even because, as Powell acknowledged to Congress this week, we can’t be sure that the inflation surge is temporary or that we are that far away from full employment.

Think of what financial markets are telling the Fed. Just as inflation spiked to 5.4% in June, the highest in 13 years, the yield on 10-year US Treasury bonds dropped to 1.3%, from 1.7% in early April. Many analysts contend this decline in bond yields signals a weaker recovery for the rest of the year: there will be less fiscal stimulus, fewer vaccinations, and the initial surge of post-pandemic reopening and enthusiastic consumption will be behind us; plus there is the ever-impending threat of new Covid variants.

With over $4 trillions more in spending now on Congress’ agenda I am not so sure about the ‘less fiscal stimulus’ part, but let’s assume this view is correct.

Then somebody should tell the stock market – the S&P 500 still hovers close to all-time highs even after yesterday’s small decline, and does not seem to anticipate a major deceleration in growth.

The argument that tightening monetary policy now could jeopardize the recovery makes no sense to me. We are enjoying one of the strongest recoveries on record. Fiscal policy is recklessly loose, with massive additional spending on the table. US households are in a strong financial position. Over half of US adults are now fully vaccinated. If with all this the recovery slows down in the second half of the year, surely it’s because potential growth is not that great, and not because of adverse shocks or lack of policy stimulus.

And if the economy’s underlying growth potential is weak, well, that’s a structural problem, not a reason to keep monetary policy on emergency setting.

There is only one argument for why tighter monetary policy could jeopardize the recovery: if you believe that the only thing that props up equity prices is the expectation that the Fed will keep providing massive amounts of liquidity forever. If that’s the case, then monetary tightening now could cause a sharp drop in the stock market, which could slow consumption and investment and hurt the recovery. But if that’s the concern, then the Fed can never tighten.

So the question for the Fed truly is: if not now, then when?

Suppose that the recovery does lose steam in the second half of this year: would that be a better time to tighten, with slower growth in activity and jobs?

Or perhaps sometime next year, as we get closer to the mid-term elections?

Maybe I am too impatient. The Fed has indicated it might eventually hike interest rates in 2023; so perhaps any form of tightening, including a reduction in the pace of asset purchases (the so-called “tapering”) should be postponed until 2023, when the pandemic shock will be truly behind us and both growth and inflation will have settled at their ‘normal’ levels (about 2% inflation and just under 2% growth, according to most official forecasts). Then we can bring monetary policy to its normal setting too.

But does anyone really believe that in 2023 we will not have new shocks or new risks to keep central bankers on their toes?

If not now, when?