Challenges in Dealing with Policy Uncertainties – Lessons from the US Central Bank

The US Fed (the US Central Bank) is the world’s most influential central bank as the US is the central economy with the US Dollar being the most popular world’s reserve currency. Therefore, the Fed’s monetary policy decisions and policy speculations affect trade and financial flows across the world. Meantime, global financial markets led by the US markets adjust frequently on various speculations by market participants over the Fed’s short-term and long-term monetary policy directions as gaged mainly from the outlook of the US inflation, unemployment and the Fed’s balance sheet composition and bet on the monetary policy cycles speculated for profit. In certain times, such speculations in fact tend to drive the Fed’s policy too.

Fed’s Present Monetary Policy Stance and the US inflation Overshoot

Consequent to the Fed’s ultra-loose policies followed since March 2020 in response to the global pandemic, money printing or the Fed’s balance sheet has expanded by almost 100% to US$ 8.2 trillion during the past 16 months (an increase of nearly 1.3 times the increase in the Fed balance sheet during the decade (2007-2016) in response to 2007-09 financial crisis) while holding inter-bank overnight interest rates (federal funds rates) at lower bound of 0-0.25% policy range. The Fed has been purchasing assets at the rate of US$ 120 bn a month to facilitate the recovery from the Pandemic. Meantime, the US inflation which has been mostly running below 2% has overshoot to 4.2% (Year-on-year basis) during the past 4 months (April-July) as compared to the Fed’s long-term inflation goal of 2% average with the gradual reopening of the economy.

As the US economy is a highly market-driven economy, market participants see the inflation outlook and speculate on Fed’s monetary policy upcoming. As a result, economists and market participants have been raising concerns over rising inflationary pressures and stressing the urgent need to commence tightening the monetary policy now to overcome such inflationary pressures in the future. The Fed’s response has been that such inflationary pressures are transitory caused by supply constraints and will disappear over time with the progress of reopening and recovery of the economy.

The Market View on Policy Tightening

The idea behind this tightening hypothesis is to mop up some of the excess money available in the economy so that the growth of the demand in the commodity market (or spending) will fall leading to lower inflation over time. This is the monetarist view on money and inflation. However, it is not that simple and straightforward due to the global impact of and reactions to the US monetary policy. Some of the new US dollar liquidity has flown to emerging markets as usual and helps their recovery. Therefore, a part of the US demand is the foreign demand for US goods and services. Therefore, any US policy tightening will adversely affect the recovery of emerging market economies due to shortages of dollar liquidity and capital outflows back to the US.

As a result, there will be a global wave of policy tightening mainly through raising interest rates to retain foreign investments in emerging markets causing global uncertainties detrimental to the US recovery too. For example, the Fed’s policy tightening by raising its federal funds rate target from 0.25%-0.50% to 2.25%-2.50% level in continuous 8 instances with 0.25% each during the 24-month period from December 2016 to December 2018 destabilized both the global economy and the US economy. In responding to the Fed’s new policy direction and signals, nearly 94 policy interest rate increases were reported from central banks around the world mainly to stabilize their foreign exchange markets for domestic stability. The then US President publicly criticized the Fed for this unwarranted policy drive and looked even for laws to fire the Fed Chair (Present one) before the term expires. The present Fed Chair recently commented that it was a policy mistake that will not happen this time.

In line with the policy reversal strategy followed by the US Fed after the recovery from the global financial crisis 2007-09, markets now speculate that the Fed would start tapering asset purchases (presently US$ 120 bn a month) first and then raising interest rates gradually so that present high inflation expectations will be lowered to be around 2% over time.

Fed Chair’s Speech at the Jackson Hole Symposium held on 27 August 2021 (Yesterday)

    This symposium is a Fed’s annual policy event held to communicate views on its policy direction to markets. The whole world waits anxiously for the speech of the Fed Chair to detect any significant policy signals that can be leaked out from his words. Therefore, prior to the event, market analysts express views on such signals possibly causing volatilities. At this time, many expected that the Fed Chair would tend to communicate on tapering timelines. However, he made a careful fact-based speech to calm down speculative minds of the markets and to communicate prevailing risks confronted by the US economy. The speech helps understand the macroeconomic insight into the Fed’s present monetary policy strategy unaffected by any external pressures.

Highlights of the Fed Chair’s Speech

• Inflation Path

The increase in inflation in personal consumption expenditure (PCE inflation) for the 12 months through July 2021 is high at 4.2% against the Fed’s average long-term target of 2% directly affected by the Pandemic and reopening of the economy. This inflation represents a narrow group of goods and services and lacks a broad-based inflation measure. Nearly one percentage to this increase is the unusual increase in consumption of durable goods due to shift of the consumption pattern from services to consumer durables in response to social distancing policies. Another 0.8 percentage is the energy prices recovered from the pandemic slum. Accordingly, price increases that may spill over to broad-based inflationary pressures is close to 2%.

Durables prices actually have declined over the 25 years preceding the pandemic with an average inflation of negative 1.9% per year. Therefore, durables inflation is unlikely to prevail.

Inflation in advanced economies has run below 2% since the 1990s, partly due to disinflationary forces such as technology, globalization and demographic factors. Underlying global disinflationary factors are likely to evolve over time and there is little reason to think that they have suddenly reversed or abated.

The present 12-month inflation calculation captures the rebound in prices with reopening of the economy and not on the prior-pandemic prices. Therefore, reported inflation is temporarily elevated and effects of rebounding prices in measured inflation should wash out over time.

Therefore, the current high inflation level is transitory due to demand-supply imbalances arising from supply difficulties and reopening of the economy.

• Path Ahead Maximum Employment

The pandemic recession displaced nearly 30 million workers in two months. The decline in the output in the second quarter 2020 was twice the full decline during the great recession of 2007-09 financial crisis.

Job gains have risen steadily this year with average 832,000 over the past three months, of which almost 800,000 in services consequent to ease of social distancing.

The unemployment has declined to 5.4% and the reported rate understates the amount of labour market slack. However, the unemployment rate ran below 4 percent for about two years before the pandemic while inflation ran at or below 2 percent.

• Wages Path

If wage increases move materially and persistently above the levels of productivity gains and inflation, businesses will pass those increases to consumers leading to a wage-price spiral. Little evidence is available on wage increases threatening excessive inflation.

• Long-term Inflation Expectations

The US monetary policy framework is to anchor long-term inflation expectations at 2% for both maximum employment and price stability objectives of the Fed. Longer-term inflation expectations have moved much less than the actual inflation or near-term expectations. This suggests that market participants also believe that current high inflation readings are likely to be transitory. In any case, the Fed will keep the inflation close 2% objective over time.

• Implications for Monetary Policy

According to research on past monetary policy actions, the main influence of monetary policy on inflation can come a lag of a year or more. He states “If a central bank tightens policy in response to factors that turn out to be temporary, the main policy effects are likely to arrive after the need has passed. The ill-timed policy move unnecessarily slows hiring and other economic activity and pushes inflation lower than desired.”

Such a mistake could be particularly harmful with substantial slack remaining in the labor market and the pandemic continuing. An extended period of unemployment can be harmful to workers and to the productive capacity of the economy.

Central banks always face the problem of separating transitory inflation spikes from more turbulent developments with confidence in real-time. At such times, there is no substitute for careful focus on incoming data and evolving risks. If sustained higher inflation were to become a serious concern, the Fed will certainly respond and use its tools to assure actual inflation runs at levels consistent with its goals.

• Monetary Policy Direction Signaled

It could be appropriate to start reducing the pace of asset purchases this year if the economy moves broadly as anticipated. Last month shows more progress of strong employment and further spread of Delta variant.

Even after Fed’s asset purchases end, its elevated holdings of longer-term securities will continue (assets rollovers) to support accommodative financial condition.

The Fed will hold the target range for the federal funds rate at the current level (0-0.25%) until the economy reaches conditions consistent with maximum employment and inflation has reached 2% and is on track to moderately exceed 2% for some time.

Lesson to Learn

    Above speech enlightens the macroeconomic outlook that should be considered before taking any policy direction and policy uncertainties frequently confronted due to ongoing shocks and market reactions. Therefore, the policy should be driven only by clear views established with the actual flow of data as any policy changes would cause macroeconomic effects even after a year, given the lagged effects of the monetary policy which cannot be forecast at the time of policymaking. For example, fix-term borrowers and investors will respond to the present monetary policy at the time of maturity of investments in the future and could cause unnecessary shocks to the economy.

    Frequent reversals of policies taken prematurely will lose the policy credibility. Therefore, views supporting premature policy tightening in fears of sudden inflationary pressures measured from a narrow consumer basket or possible assets bubble concerns over prevailing excess liquidity in the emerging market economies in the middle of the new Delta pandemic and related uncertainties will no doubt cause considerable risks to those economies. Policy reactions among them to fight capital flows also will be destabilizing. The increased cost on the fiscal financing required for ongoing public stimulus packages at this pandemic time will cause losses to the public.

    As such inflationary pressures have risen from changes in the consumption pattern with the reduction in services consumption and the increase in basic food consumption and supply constraints in the middle of still spreading Pandemic and reopening difficulties. In this circumstance, as inflationary pressures are misleading, any policy tightening based on inflationary pressures only is not warranted until the actual data shows that the recovery of the economy is firm and sustainable.

    There is no rocket science or mathematical models to make the policy decision at the correct time. It is the use of wisdom supported by actual data and experience with the real interest and feelings for the public by leaving out old schools of thought.

P. Samarasiri

Former Deputy Governor, Central Bank of Sri Lanka