Too little and too late at the Fed

In announcing its decision Wednesday to start tapering its bond buying program, the Federal Reserve has finally taken a step in the right direction. But not only has this step been ever so late in coming. It falls painfully short of allowing the Fed to meet its longer-run objectives of low inflation and financial market stability.

To be sure, the Fed has now announced that it will start tapering the current monthly $120 billion pace at which it has been buying U.S. Treasury bonds and mortgage-backed securities. It will do so by reducing that pace by $15 billion a month with a view to ending the bond buying program by June 2022.

While the Fed will now start tapering, it does not plan to start raising its policy interest rate from its zero bound until sometime in 2023. Since inflation as measured by the Personal Consumer Expenditure deflator, the Fed’s favorite inflation yardstick, is more than likely to remain at least at its current 4 percent rate for the next few months, this means that in inflation-adjusted terms interest rates will remain significantly negative for some time. 

The Fed’s decision to start tapering does not mean it is adopting a tight monetary policy. Indeed, over the next eight months, the Fed will continue to buy another $540 billion in bonds, and it will still have to keep interest rates at their zero bound. A better way to characterize the Fed’s planned policy action is as a move from a very, very, expansive monetary policy to one that is only a very expansive monetary policy. 

The maintenance of a very expansive policy made sense last year when the economy was struggling and inflation was quiescent. But that is hardly the case today. The economy has long since regained its pre-pandemic level, and inflation is now running at its fastest pace in the past three decades.

It also makes little sense to keep monetary policy highly expansive when labor shortages are adding to wage pressure and long-run inflationary expectations have already risen to levels that significantly exceed the Fed’s 2 percent inflation target. This is especially true at a time that the U.S. economy is receiving its largest peacetime budget stimulus on record and that global supply chain shortages, global shipping problems, rapid house price inflation and high international oil prices are likely to keep inflation high for much longer than the Fed had earlier expected. 

The Fed also appears to be undermining longer-run financial market stability by continuing to keep interest rates at their zero bound and by continuing to buy large amounts of government bonds and mortgage-backed securities, albeit at a slower pace than before. Such a loose monetary policy approach runs the real risk of adding additional froth to already over-stretched equity, housing and credit markets. This must be of particular concern at a time that U.S. equity valuations are at levels experienced only once before in the last 100 years. It also must be of concern at a time that housing prices adjusted for inflation are now at around their level immediately preceding the 2006 housing bust. How quickly the Fed seems to have forgotten how economically painful the bursting of asset price bubbles can be.

In short, at best Wednesday’s Fed policy move can be described as a very small step in the right direction. Disappointingly, it is unlikely to bring down today’s troubling inflation anytime soon, and it is likely to add further froth to already overheated asset price and credit markets.

Let’s hope that the Fed’s present state of denial about the inflation and the asset price inflation risks that it is running is associated with President Biden’s delay in nominating Fed Chair Jerome Powell for a second term when his current term expires in February. Maybe once the nomination issue is sorted out, the Fed might act in a manner more consistent with the long-run attainment of its dual price stability and high employment mandate.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.