How the Fed Fell Behind the Curve

In order to achieve the dual mandate to promote maximum employment and price stability, the Fed has been setting monetary polices under a framework laid out by its “Statement on Longer-Run Goals and Monetary Policy Strategy“ (the Statement). In the pre-pandemic versions, the Statement directed the Fed to ‘firmly’ anchor inflation at 2%, target the unemployment rate at the FOMC’s projection (4.4% in 2019), and take a ‘balanced’ approach between the two sides of the dual mandate.

Implementing this framework in the real world involves estimating the natural rate of unemployment and gauging progress toward the dual mandate. As demonstrated by the 2015-2018 tightening cycle, both can be fairly difficult. A very low unemployment rate tends to push up inflation. This inverse relationship is called the Phillips curve. In 2015, when the unemployment rate dropped below 5.2% (the estimated natural rate at the time), the Fed started to have concerns about future inflation and promptly kicked off the normalization process. Rates were raised in late 2015, followed by balance sheet reduction in 2018. In the end, however, the inflation worry never materialized, but burgeoning job and wage growth for lower income workers were stalled because of the tightening, which in hindsight some think was unnecessary. Fed Chair Powell later admitted before Congress that the natural rate of unemployment was miscalculated.

Carrying this regret in the unprecedented economic and political environments after the lockdown-induced recession, the Fed decided to make it right the second time around. On August 27, 2020, Fed Chairman Jerome Powell announced major monetary policy changes during a virtual speech at the annual Jackson Hole symposium. In the updated Statement, employment was given higher priority than inflation, numerical benchmarks became less of a reference, and the balanced approach was no longer emphasized. Because maximum employment is determined by non-monetary factors largely out of the Fed’s hands, the financial markets widely interpreted these changes as the Fed’s commitment to keep interest rates lower for much longer to foster favorable economic conditions.

In a sense more significantly, the 2020 update of the Statement marked a shift from rules to discretion. Bouncing back from the 1970s’ “greatest failure of American macroeconomic policy in the postwar period”, the Fed moved toward consulting policy rules for an objective view on what the neutral interest rate should be. Data has shown that the federal funds rate in the last three decades, including the 2015-2018 period, has been following some version of the Taylor rule. The rule gives a straightforward equation to estimate the neutral policy rate in response to the inflation gap (deviation from inflation target) and the resource gap (deviation from either neutral GDP growth or natural unemployment rate). It comes in a variety of forms that utilize either resource gap measure and give the gaps different weights.

At the time of Mr. Powell’s speech, the unemployment rate was 8.4%, the core PCE was 1.5%, and the Taylor rule implied rates were either close to zero or highly negative. The risk of taking an alternative policy approach following a long decade of low inflation therefore was not immediately clear. In fact, both Ms. Yellen and Mr. Bernanke praised the change. In the next few months, however, the economy zoomed back on the back of the vaccine and the massive fiscal and monetary stimulus. By November 2021, when the unemployment rate fell below 4.4% for the first time since the pandemic started, the headline PCE reached 5.6%, and the core PCE was at 4.7%, well above 2% and a level not seen since 1989. The Taylor rule started to call for a policy rate around 5%.

In early 2022, the gap between the actual federal funds rate and the Taylor rule implied rates widened to 7-10%. It became increasingly clear that the Fed was behind the curve. But the first rate hike didn’t come until March and was a petite 25bp. In May 2022, Mr. Powell said the Fed was not “actively considering” a 75bp hike, only for it to hike by exactly 75bp in the following month. June’s headline CPI now came out to be 9.1%, fueling speculation of a 75-100bp hike later this month.

The comeback economy is not the same one we lost. It is crippled by supply chain disruptions, shifting demands, and low labor participation, all beyond the Fed’s control. These unforeseeable economic developments have challenged the discretionary policy-making that effectively unanchored inflation and has no roadmap resilient to surprises. The resulting record-high inflation took a toll on American families and businesses, but arguably letting it run this hot still failed to achieve the Fed’s desired outcome of “broad-based and inclusive” employment. To date non-farm payroll hasn’t yet fully made it back to the pre-pandemic level, the unemployment rate gaps among different subgroups are persistent, overall the creation and recovery of blue-collar jobs fell behind that of white-collar jobs, and most devastatingly, real wages broadly declined.

Mr. Powell said in May that the Fed now wants to reduce job openings to curb wage growth and inflation. In June he testified before the Senate Banking Committee that by the end of this year, rates should return to where the Taylor rule prescribes. He also said that hiking rates to fight inflation will cause a rise in unemployment in the years ahead, but it may be a worthwhile tradeoff for a healthy economy.

In a dynamic world, the Fed’s stand on inflation affects inflation expectations, which in turn affects realized inflation in the long run. Maybe the low inflation in the 2010s was after all not a breakdown of the Phillips Curve, but rather the result of a disciplined inflation approach. Monetary policy has response lag. As the core PCE starts to show signs of peaking, the Fed’s dramatic rate catch-up will have a better chance to avoid over-correction and getting it wrong twice by returning to the data- and rule-based framework.