Quantitative Easing

The Fed should raise interest rates, but gently

The Federal Reserve could face a series of tough calls in 2022 and, naturally, all eyes in the financial markets will be watching. What will the Federal Open Market Committee do? What does he have to do ?

Try to put yourself in the shoes of President Jerome Powell. He is intelligent, thoughtful and calm – a man who does not go to extremes. He must also forge a consensus within a committee that is far from united. Yet it is “assessed” every day by thousands of stock and bond traders who, though intelligent, are often neither thoughtful nor calm and regularly go to extremes. The two points of view do not correspond.

The FOMC’s first steps are clear, and they were more or less announced at the January 25-26 meeting. With an economy essentially at “maximum employment” and inflation far too high, the Fed needs to stop expanding its balance sheet and start raising interest rates. Both of these policy changes are obvious and coming, albeit a bit late.

In signaling its intention to raise rates, the FOMC used the word “soon”. Translating from Fedspeak to English, this means that the fed funds target will increase at the next FOMC meeting, unless something very strange happens by March 16th. It is also extremely likely that the first rate hike will be only 25 basis points and not the last.

But how high will rates go and how fast? This is where the decisions start to get tough.

Ahead of January’s FOMC meeting, a strong minority of market chatter shouted that the Fed was behind the curve and called on the committee to create a hawkish surprise on January 26, such as raising interest rates that day or calling a immediate end to quantitative easing. Mr. Powell and his colleagues, being far less excitable, hesitated. But they struck a more hawkish tone, making it clear that tighter money — or, more accurately, less easy money — is coming.

He is. But Fed watchers need to understand that after modest tightening, the central bank will consider a two-sided risk.

Yes, as the warts of worry say, inflation is far too high today, and there is a risk that it will remain so for too long. The hawks are also right to point out that the Fed is behind the curve and needs to catch up. Finally, they’re right to point out that Team Transitory’s inflation forecast hasn’t been good so far. (Confession: I’m a member.) With inflation stubbornly high, we could be on the cusp of a serious rate hike cycle.

May be. But there are also risks on the other side.

Start with the request. Above all, Covid-19 is still with us. Fear of infection appears to have weighed heavily on retail sales in December, and this could continue well into 2022. Second, the massive fiscal support that helped fuel spending in 2020 and 2021 has mostly disappeared. . In fact, the fiscal squeeze is reversing. Third, businesses will not continue to hoard inventory at the incredibly high rates of the fourth quarter of 2021. This all adds up to slower demand growth in 2022 than in 2021.

On the supply side, while Omicron is keeping many workers sick or in quarantine because they have been exposed, it seems to be easing off quickly. The data also suggests that supply chains are starting to cope better with the increased demand for items delivered in boxes. There’s even a hint in recent data that consumer spending habits are shifting towards services, which don’t come in boxes.

Finally, let me add the “risk” that Team Transitory turns out to be right, and inflation falls faster than the hawks expect. The latest forecast released by the Fed (in December) predicted inflation of 2.6% over the four quarters of 2022, as measured by its favorite index, the personal consumption expenditure deflator, or PCE. If something like this were to happen, PCE inflation would be pretty close to the Fed’s 2% target by the end of the year.

Here, then, is a scenario that the inflation hawks are not counting on. By the end of 2022, economic growth could be slow, the unemployment rate could be stable or slowly increasing, and the inflation rate could be almost back to 2%. If that’s what the future holds, the Fed will want to be cautious about how quickly and how much interest rates will rise in the first half of 2022. Sure, but wisely.

Based on what we’re seeing today, that last “happy” scenario isn’t the best guess. But he’s not crazy either. So if you’re smart, thoughtful, calm, and not prone to extremes, you’ll want to take that into account and wait to see how things pan out. Humble and agile, you might say.

Mr. Blinder, a professor of economics and public affairs at Princeton, served as vice chairman of the Federal Reserve from 1994 to 1996.

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