Photo from the Associated Press of Fed Chair Jerome Powell at a news conference
At its Wednesday, May 3, 2023 meeting, the Federal Open Market Committee (FOMC) raised its target for the federal funds rate by 0.25 percentage point to a range of 5.00 to 5.25. The decision by the committee’s 11 voting members was unanimous. After each meeting, the FOMC releases a statement (the statement for this meeting can be found here) explaining its reasons for its actions at the meeting.
The statement for this meeting had a key change from the statement the committee issued after its last meeting on March 22. The previous statement (found here) included this sentence:
“The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time.”
In the statement for this meeting, the committee rewrote that sentence to read:
“In determining the extent to which additional policy firming may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.”
This change indicates that the FOMC has stopped—or at least suspended—use of forward guidance. As we explain in Money, Banking, and the Financial System, Chapter 15, Section 5.2, forward guidance refers to statements by the FOMC about how it will conduct monetary policy in the future.
After the March meeting, the committee was providing investors, firms, and households with the forward guidance that it intended to continue raising its target for the federal funds rate—which is what the reference to “additional policy firming” means. The statement after the May meeting indicated that the committee was no longer giving guidance about future changes in its target for the federal funds rate other than to state that it would depend on the future state of the economy. In other words, the committee was indicating that it might not raise its target for the federal funds rate after its next meeting on June 14. The committee didn’t indicate directly that it was pausing further increases in the federal funds rate but indicated that pausing further increases was a possible outcome.
Following the end of the meeting, Fed Chair Jerome Powell conducted a press conference. Although not yet available when this post was written, a transcript will be posted to the Fed’s website here. Powell made the following points in response to questions:
He was not willing to move beyond the formal statement to indicate that the committee would pause further rate increases.
He believed that the bank runs that had led to the closure and sale of Silicon Valley Bank, Signature Bank, and First Republic Bank were likely to be over. He didn’t believe that other regional banks were likely to experience runs. He indicated that the Fed needed to adjust its regulatory and supervisory actions to help ensure that similar runs didn’t happen in the future.
He repeated that he believed that the Fed could achieve its target inflation rate of 2 percent without the U.S. economy experiencing a recession. In other words, he believed that a soft landing was still possible. He acknowledged that some other members of the committee and the committee’s staff economist disagreed with him and expected a mild recession to occur later this year.
He stated that as banks have attempted to become more liquid following the failure of the three regional banks, they have reduced the volume of loans they are making. This credit contraction has an effect on the economy similar to that of an increase in the federal funds rate in that increases in the target for the federal funds rate are also intended to reduce demand for goods, such as housing and business fixed investment, that depend on borrowing. He noted that both those sectors had been contracting in recent months, slowing the economy and potentially reducing the inflation rate.
He indicated that although inflation had declined somewhat during the past year, it was still well above the Fed’s target. He mentioned that wage increases were still higher than is consistent with an inflation rate of 2 percent. In response to a question, he indicated that if the inflation rate were to fall from current rates above 4 percent to 3 percent, the FOMC would not be satisfied to accept that rate. In other words, the FOMC still had a firm target rate of 2 percent.
In summary, the FOMC finds itself in the same situation it has been in since it began raising its target for the federal funds rate in March 2022: Trying to bring high inflation rates back down to its 2 percent target without causing the U.S. economy to experience a significant recession.
The Federal Reserve’s goal has been to end the current period of high inflation by bringing the economy in for a soft landing—reducing the inflation rate to closer to the Fed’s 2 percent target while avoiding a recession. Although Fed Chair Jerome Powell has said repeatedly during the last year that he expected the Fed would achieve a soft landing, many economists have been much more doubtful.
It’s possible to read recent economic data as indicating that it’s more likely that the economy is approaching a soft landing, but there is clearly still a great deal of uncertainty. On April 12, the Bureau of Labor Statistics released the latest CPI data. The figure below shows the inflation rate as measured by the CPI (blue line) and by core CPI—which excludes the prices of food and fuel (red line). In both cases the inflation rate is the percentage change from the same month in the previous year.
The inflation rate as measured by the CPI has been trending down since it hit a peak of 8.9 percent in June 2022. The inflation rate as measured by core CPI has been trending down more gradually since it reached a peak of 6.6 percent in September 2022. In March, it was up slightly to 5.6 percent from 5.5 percent in February.
As the following figure shows, payroll employment while still increasing, has been increasing more slowly during the past three months—bearing in mind that the payroll employment data are often subject to substantial revisions. The slowing growth in payroll employment is what we would expect with a slowing economy. The goal of the Fed in slowing the economy is, of course, to bring down the inflation rate. That payroll employment is still growing indicates that the economy is likely not yet in a recession.
The slowing in employment growth has been matched by slowing wage growth, as measured by the percentage change in average hourly earnings. As the following figure shows, the rate of increase in average hourly earnings has declined from 5.9 percent in March 2022 to 4.2 percent in March 2023. This decline indicates that businesses are experiencing somewhat lower increases in their labor costs, which may pass through to lower increases in prices.
Credit conditions also indicate a slowing economy As the following figure shows, bank lending to businesses and consumers has declined sharply, partly because banks have experienced an outflow of deposits following the failure of Silicon Valley and Signature Banks and partly because some banks have raised their requirements for households and firms to qualify for loans in anticipation of the economy slowing. In a slowing economy, households and firms are more likely to default on loans. To the extent that consumers and businesses also anticipate the possibility of a recession, they may have reduced their demand for loans.
But such a sharp decline in bank lending may also be an indication that the economy is not just slowing, on its way to a making a soft landing, but is on the verge of a recession. The minutes of the March meeting of the Federal Open Market Committee (FOMC) included the information that the FOMC’s staff economists forceast “at the time of the March meeting included a mild recession starting later this year, with a recovery over the subsequent two years.” (The minutes can be found here.) The increased chance of a recession was attributed largely to “banking and financial conditions.”
At its next meeting in May, the FOMC will have to decide whether to once more increase its target range for the federal funds rate. The target range is currently 4.75 percent to 5.00 percent. The FOMC will have to decide whether inflation is on a course to fall back to the Fed’s 2 percent target or whether the FOMC needs to further slow the economy by increasing its target range for the federal funds rate. One factor likely to be considered by the FOMC is, as the following figure shows, the sharp difference between the inflation rate in prices of goods (blue line) and the inflation rate in prices of services (red line).
During the period from January 2021 to November 2022, inflation in goods was higher—often much higher—than inflation in services. The high rates of inflation in goods were partly the result of disruptions to supply chains resulting from the Covid-19 pandemic and partly due to a surge in demand for goods as a result of very expansionary fiscal and monetary policies. Since November 2022, inflation in the prices of services has remained high, while inflation in the prices of goods has continued to decline. In March, goods inflation was only 1.6 percent, while services inflation was 7.2 percent. In his press conference following the last FOMC meeting, Fed Chair Jerome Powell stated that as long as services inflation remains high “it would be very premature to declare victory [over inflation] or to think that we’ve really got this.” (The transcript of Powell’s news conference can be found here.) This statement coupled with the latest data on service inflation would seem to indicate that Powell will be in favor of another 0.25 percentage point increase in the federal funds rate target range.
The Fed’s inflation target is stated in terms of the personal consumption expenditure (PCE) price index, not the CPI. The Bureau of Economic Analysis will release the March PCE on April 28, before the next FOMC meeting. If the Fed is as closely divided as it appears to be over whether additional increases in the federal funds rate target range are necessary, the latest PCE data may prove to have a significan effect on their decision.
So—as usual!—the macroeconomic picture is murky. The economy appears to be slowing and inflation seems to be declining but it’s still difficult to determine whether the Fed will be able to bring inflation back to its 2 percent target without causing a recession.
Fed Chair Jerome Powell holding a news conference following the March 22 meeting of the FOMC. Photo from Reuters via the Wall Street Journal.
On March 22, the Federal Open Market Committee (FOMC) unanimously voted to raise its target for the federal funds rate by 0.25 percentage point to a range of 4.75 percent to 5.00 percent. The members of the FOMC also made economic projections of the values of certain key economic variables. (We show a table summarizing these projections at the end of this post.) The summary of economic projections includes the following “dot plot” showing each member of the committee’s forecast of the value of the federal funds rate at the end of each of the following years. Each dot represents one member of the committee.
If you focus on the dots above “2023” on the vertical axis, you can see that 17 of the 18 members of the FOMC expect that the federal funds rate will end the year above 5 percent.
In a press conference after the committee meeting, a reporter asked Fed Chair Jerome Powell was asked this question: “Following today’s decision, the [financial] markets have now priced in one more increase in May and then every meeting the rest of this year, they’re pricing in rate cuts.” Powell responded, in part, by saying: “So we published an SEP [Summary of Economic Projections] today, as you will have seen, it shows that basically participants expect relatively slow growth, a gradual rebalancing of supply and demand, and labor market, with inflation moving down gradually. In that most likely case, if that happens, participants don’t see rate cuts this year. They just don’t.” (Emphasis added. The whole transcript of Powell’s press conference can be found here.)
Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk–such as a sudden increase in oil prices or in interest rates–and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banks, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart shows values after trading of federal funds futures on March 24, 2023.
The chart shows six possible ranges for the federal funds rate after the FOMC’s last meeting in December 2023. Note that the ranges are given in basis points (bps). Each basis point is one hundredth of a percentage point. So, for instance, the range of 375-400 equals a range of 3.75 percent to 4.00 percent. The numbers at the top of the blue rectangles represent the probability that investors place on that range occurring after the FOMC’s December meeting. So, for instance, the probability of the federal funds rate target being 4.00 percent to 4.25 percent is 28.7 percent. The sum of the probabilities equals 1.
Note that the highest target range given on the chart is 4.50 percent to 4.75 percent. In other words, investors in financial markets are assigning a probability of zero to an outcome that the dot plot shows 17 of 18 FOMC members believe will occur: A federal funds rate greater than 5 percent. This is a striking discrepancy between what the FOMC is announcing it will do and what financial markets think the FOMC will actually do.
In other words, financial markets are indicating that actual Fed policy for the remainder of 2023 will be different from the policy that the Fed is indicating it intends to carry out. Why don’t financial markets believe the Fed? It’s impossible to say with certainty but here are two possibilities:
Markets may believe that the Fed is underestimating the likelihood of an economic recession later this year. If an economic recession occurs, markets assume that the FOMC will have to pivot from increasing its target for the federal funds rate to cutting its target. Markets may be expecting that the banks will cut back more on the credit they offer households and firms as the banks prepare to deal with the possibility that substantial deposit outflows will occur. The resulting credit crunch would likely be enough to push the economy into a recession.
Markets may believe that members of the FOMC are reluctant to publicly indicate that they are prepared to cut rates later this year. The reluctance may come from a fear that if households, investors, and firms believe that the FOMC will soon cut rates, despite continuing high inflation rates, they may cease to believe that the Fed intends to eventually bring the inflation back to its 2 percent target. In Fed jargon, expectations of inflation would cease to be “anchored” at 2 percent. Once expectations become unanchored, higher inflation rates may become embedded in the economy, making the Fed’s job of bringing inflation back to the 2 percent target much harder.
In late December, we can look back and determine whose forecast of the federal funds rate was more accurate–the market’s or the FOMC’s.
At the conclusion of its meeting today (March 22, 2023), the Federal Reserve’s Federal Open Market Committee (FOMC) announced that it was raising its target for the federal funds rate from a range of 4.50 percent to 4.75 percent to a range of 4.75 percent to 5.00 percent. As we discussed in this recent blog post, the FOMC was faced with a dilemma. Because the inflation rate had remained stubbornly high at the beginning of this year and consumer spending and employment had been strongly increasing, until a couple of weeks ago, financial markets and many economists had been expecting a 0.50 percentage point (or 50 basis point) increase in the federal funds rate target at this meeting. As the FOMC noted in the statement released at the end of the meeting: “Job gains have picked up in recent months and are running at a robust pace; the unemployment rate has remained low. Inflation remains elevated.”
But increases in the federal funds rate lead to increases in other interest rates, including the interest rates on the Treasury securities and mortgage-backed securities that most banks own. On Friday, March 10, the Federal Deposit Insurance Corporation (FDIC) was forced to close the Silicon Valley Bank (SVB) because the bank had experienced a deposit run that it was unable to meet. The run on SVB was triggered in part by the bank taking a loss on the Treasury securities it sold to raise the funds needed to cover earlier deposit withdrawals. The FDIC also closed New York-based Signature Bank. San Francisco-based First Republic Bank experienced substantial deposit withdrawals, as we discussed in this blog post. In Europe, the Swiss bank Credit Suisse was only saved from failure when Swiss bank regulators arranged for it to be purchased by UBS, another Swiss bank. These problems in the banking system led some economists to urge that the FOMC keep its target for the federal funds rate unchanged at today’s meeting.
Instead, the FOMC took an intermediate course by raising its target for the federal funds rate by 0.25 percentage point rather than by 0.50 percentage point. In a press conference following the announcement, Fed Chair Jerome Powell reinforced the observation from the FOMC statement that: “Recent developments are likely to result in tighter credit conditions for households and businesses and to weigh on economic activity, hiring, and inflation.” As banks, particularly medium and small banks, have lost deposits, they’ve reduced their lending. This reduced lending can be a particular problem for small-to medium-sized businesses that depend heavily on bank loans to meet their credit needs. Powell noted that the effect of this decline in bank lending on the economy is the equivalent of an increase in the federal funds rate.
The FOMC also released its Summary of Economic Projections (SEP). As Table 1 shows, committee members’ median forecast for the federal funds rate at the end of 2023 is 5.1 percent, indicating that the members do not anticipate more than a single additional 0.25 percentage point increase in the target for the federal funds rate. The members expect a significant increase in the unemployment rate from the current 3.6 percent to 4.5 percent at the end of 2023 as increases in interest rates slow down the growth of aggregate demand. They expect the unemployment rate to remain in that range through the end of 2025 before declining to the long-run rate of 4.0 percent in later years. The members expect the inflation rate as measured by the personal consumption (PCE) price index to decline from 5.4 percent in January to 3.3 percent in December. They expect the inflation rate to be back close to their 2 percent target by the end of 2025.
The Federal Reserve building in Washington, DC. (Photo from the Wall Street Journal.)
In the Federal Reserve Act, Congress charged the Federal Reserve with conducting monetary policy so as to achieve both “maximum employment” and “stable prices.” These two goals are referred to as the Fed’s dual mandate. (We discuss the dual mandate in Macroeconomics, Chapter 15, Section 15.1, Economics, Chapter 25, Section 25.1, and Money, Banking, and the Financial System, Chapter 15, Section 15.1.) Accordingly, when Fed chairs give their semiannual Monetary Policy Reports to Congress, they reaffirm that they are acting consistently with the dual mandate. For example, when testifying before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in June 2022, Fed Chair Jerome Powell stated that: “The Fed’s monetary policy actions are guided by our mandate to promote maximum employment and stable prices for the American people.”
Despite statements of that kind, some economists argue that in practice during some periods the Fed’s policymaking Federal Open Market Committee (FOMC) acts as if it were more concerned with one of the two mandates. In particular, in the decades following the Great Inflation of the 1970s, FOMC members appear to have put more emphasis on price stability than on maximum employment. These economists argue that during these years, FOMC members were typically reluctant to pursue a monetary policy sufficiently expansionary to lead to maximum employment if the result would be to cause the inflation rate to rise above the Fed’s target of an annual target of 2 percent. (Although the Fed didn’t announce a formal inflation target of 2 percent until 2012, the FOMC agreed to set a 2 percent inflation target in 1996, although they didn’t publicly announce at the time. Implicitly, the FOMC had been acting as if it had a 2 percent target since at least the mid–1980s.)
In July 2019, the FOMC responded to a slowdown in economic growth in late 2018 and early 2019 but cutting its target for the federal funds rate. It made further cuts to the target rate in September and October 2019. These cuts helped push the unemployment rate to low levels even as the inflation rate remained below the Fed’s 2 percent target. The failure of inflation to increase despite the unemployment rate falling to low levels, provides background to the new monetary policy strategy the Fed announced in August 2020. The new monetary policy, in effect, abandoned the Fed’s previous policy of attempting to preempt a rise in the inflation rate by raising the target for the federal funds rate whenever data on unemployment and real GDP growth indicated that inflation was likely to rise. (We discussed aspects of the Fed’s new monetary policy in previous blog posts, including here, here, and here.)
In particular, the FOMC would no longer see the natural rate of unemployment as the maximum level of employment—which Congress has mandated the Fed to achieve—and, therefore, wouldn’t necessarily begin increasing its target for the federal funds rate when the unemployment rate dropped by below the natural rate. As Fed Chair Powell explained at the time, “the maximum level of employment is not directly measurable and [it] changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point.”
Many economists interpreted the Fed’s new monetary strategy and the remarks that FOMC members made concerning the strategy as an indication that the Fed had turned from focusing on the inflation rate to focusing on unemployment. Of course, given that Congress has mandated the Fed to achieve both stable prices and maximum employment, neither the Fed chair nor other members of the FOMC can state directly that they are focusing on one mandate more than the other.
The sharp acceleration in inflation that began in the spring of 2021 and continued into the fall of 2022 (shown in the following figure) has caused members of the FOMC to speak more forcefully about the need for monetary policy to bring inflation back to the Fed’s target rate of 2 percent. For example, in a speech at the Federal Reserve Bank of Kansas City’s annual monetary policy conference held in Jackson Hole, Wyoming, Fed Chair Powell spoke very directly: “The Federal Open Market Committee’s (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal.” According to an article in the Wall Street Journal, Powell had originally planned a longer speech discussing broader issues concerning monetary policy and the state of the economy—typical of the speeches that Fed chairs give at this conference—before deciding to deliver a short speech focused directly on inflation.
Members of the FOMC were concerned that a prolonged period of high inflation rates might lead workers, firms, and investors to no longer expect that the inflation rate would return to 2 percent in the near future. If the expected inflation rate were to increase, the U.S. economy might enter a wage–price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage–price spiral in earlier blog posts here and here.)
With Powell noting in his Jackson Hole speech that the Fed would be willing to run the risk of pushing the economy into a recession if that was required to bring down the inflation rate, it seemed clear that the Fed was giving priority to its mandate for price stability over its mandate for maximum employment. An article in the Wall Street Journal quoted Richard Clarida, who served on the Fed’s Board of Governors from September 2018 until January 2022, as arguing that: “Until inflation comes down a lot, the Fed is really a single mandate central bank.”
This view was reinforced by the FOMC’s meeting on September 21, 2022 at which it raised its target for the federal funds rate by 0.75 percentage points to a range of 3 to 3.25 percent. The median projection of FOMC members was that the target rate would increase to 4.4 percent by the end of 2022, up a full percentage point from the median projection at the FOMC’s June 2022 meeting. The negative reaction of the stock market to the announcement of the FOMC’s decision is an indication that the Fed is pursuing a more contractionary monetary policy than many observers had expected. (We discuss the relationship between stock prices and economic news in this blog post.)
Some economists and policymakers have raised a broader issue concerning the Fed’s mandate: Should Congress amend the Federal Reserve Act to give the Fed the single mandate of achieving price stability? As we’ve already noted, one interpretation of the FOMC’s actions from the mid–1980s until 2019 is that it was already implicitly acting as if price stability were a more important goal than maximum employment. Or as Stanford economist John Cochrane has put it, the Fed was following “its main mandate, which is to ensure price stability.”
The main argument for the Fed having price stability as its only mandate is that most economists believe that in the long run, the Fed can affect the inflation rate but not the level of potential real GDP or the level of employment. In the long run, real GDP is equal to potential GDP, which is determined by the quantity of workers, the capital stock—including factories, office buildings, machinery and equipment, and software—and the available technology. (We discuss this point in Macroeconomics, Chapter 13, Section 13.2 and in Economics, Chapter 23, Section 23.2.) Congress and the president can use fiscal policy to affect potential GDP by, for example, changing the tax code to increase the profitability of investment, thereby increasing the capital stock, or by subsidizing apprentice programs or taking other steps to increase the labor supply. But most economists believe that the Fed lacks the tools to achieve those results.
Economists who support the idea of a single mandate argue that the Fed would be better off focusing on an economic variable they can control in the long run—the inflation rate—rather than on economic variables they can’t control—potential GDP and employment. In addition, these economists point out that some foreign central banks have a single mandate to achieve price stability. These central banks include the European Central Bank, the Bank of Japan, and the Reserve Bank of New Zealand.
Economists and policymakers who oppose having Congress revise the Federal Reserve Act to give the Fed the single mandate to achieve price stability raise several points. First, they note that monetary policy can affect the level of real GDP and employment in the short run. Particularly when the U.S. economy is in a severe recession, the Fed can speed the return to full employment by undertaking an expansionary policy. If maximum employment were no longer part of the Fed’s mandate, the FOMC might be less likely to use policy to increase the pace of economic recovery, thereby avoiding some unemployment.
Second, those opposed to the Fed having single mandate argue that the Fed was overly focused on inflation during some of the period between the mid–1980s and 2019. They argue that the result was unnecessarily low levels of employment during those years. Giving the Fed a single mandate for price stability might make periods of low employment more likely.
Finally, because over the years many members of Congress have stated that the Fed should focus more on maximum employment than price stability, in practical terms it’s unlikely that the Federal Reserve Act will be amended to give the Fed the single mandate of price stability.
In the end, the willingness of Congress to amend the Federal Reserve Act, as it has done many times since initial passage in 1914, depends on the performance of the U.S. economy and the U.S. financial system. It’s possible that if the high inflation rates of 2021–2022 were to persist into 2023 or beyond, Congress might revise the Federal Reserve Act to change the Fed’s approach to fighting inflation either by giving the Fed a single mandate for price stability or in some other way.
Sources: Board of Governors of the Federal Reserve System, “Federal Reserve Issues FOMC Statement,” federalreserve.gov, September 21, 2022; Board of Governors of the Federal Reserve System, “Summary of Economic Projections,” federalreserve.gov, September 21, 2022; Nick Timiraos, “Jerome Powell’s Inflation Whisperer: Paul Volcker,” Wall Street Journal, September 19, 2022; Matthew Boesler and Craig Torres, “Powell Talks Tough, Warning Rates Are Going to Stay High for Some Time,” bloomberg.com, August 26, 2022; Jerome H. Powell, “Semiannual Monetary Policy Report to the Congress,” June 22, 2022, federalreserve.gov; Jerome H. Powell, “Monetary Policy and Price Stability,” speech delivered at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, federalreserve.gov, August 26, 2022; John H. Cochrane, “Why Isn’t the Fed Doing its Job?” project-syndicate.org, January 19, 2022; Board of Governors of the Federal Reserve System, “Minutes of the Federal Open Market Committee Meeting on July 2–3, 1996,” federalreserve.gov; and Federal Reserve Bank of St. Louis.
On September 16, 2022 an article in the Wall Street Journal had the headline: “Economic Worries, Weak FedEx Results Push Stocks Lower.” Another article in the Wall Street Journal noted that: “The company’s downbeat forecasts, announced Thursday, intensified investors’ macroeconomic worries.”
Why would the news that FedEx had lower revenues than expected during the preceding weeks cause a decline in stock market indexes like the Dow Jones Industrial Average and the S&P 500? As the article explained: “Delivery companies [such as FedEx and its rival UPS) are the proverbial canary in the coal mine for the economy.” In other words, investors were using FedEx’s decline in revenue as a leading indicator of the business cycle. A leading indicator is an economic data series—in this case FedEx’s revenue—that starts to decline before real GDP and employment in the months before a recession and starts to increase before real GDP and employment in the months before a recession reaches a trough and turns into an expansion.
So, investors were afraid that FedEx’s falling revenue was a signal that the U.S. economy would soon enter a recession. And, in fact, FedEx CEO Raj Subramaniam was quoted as believing that the global economy would fall into a recession. As firms’ profits decline during a recession so, typically, do the prices of the firms’ stock. (As we discuss in Macroeconomics, Chapter 6, Section 6.2 and in Economics, Chapter 8, Section 8.2, stock prices reflect investors’ expectations of the future profitability of the firms issuing the stock.)
Monitoring fluctuations in FedEx’s revenue for indications of the future course of the economy is nothing new. When Alan Greenspan was chair of the Federal Reserve from 1987 to 2006, he spoke regularly with Fred Smith, the founder of FedEx and at the time CEO of the firm. Greenspan believed that changes in the number of packages FedEx shipped gave a good indication of the overall state of the economy. FedEx plays such a large role in moving packages around the country that most economists agree that there is a close relationship between fluctuations in FedEx’s business and fluctuations in GDP. Some Wall Street analysts refer to this relationship as the “FedEx Indicator” of how the economy is doing.
In September 2022, the FedEx indicator was blinking red. But the U.S. economy is complex and fluctuations in any indicator can sometimes provide an inaccurate forecast of when a recession will begin or end. And, in fact, some investment analysts believed that problems at FedEx may have been due as much to mistakes the firms’ managers had made as to general problems in the economy. As one analyst put it: “We believe a meaningful portion of FedEx’s missteps here are company-specific.”
At this point, Fed Chair Jerome Powell and the other members of the Federal Open Market Committee are still hoping that they can bring the economy in for a soft landing—bringing inflation down closer to the Fed’s 2 percent target, without bringing on a recession—despite some signals, like those being given by the FedEx indicator, that the probability of the United States entering a recession was increasing.
Sources: Will Feuer, “FedEx Stock Tumbles More Than 20% After Warning on Economic Trends,” Wall Street Journal, September 16, 2022; Alex Frangos and Hannah Miao, “ FedExt Stock Hit by Profit Warning; Rivals Also Drop Amid Recession Fears,” Wall Street Journal, September 16, 2022; Richard Clough, “FedEx has Biggest Drop in Over 40 Years After Pulling Forecast,” bloomberg.com, September 16, 2022; and David Gaffen, “The FedEx Indicator,” Wall Street Journal, February 20, 2007.
On Tuesday, August 30, 2022, the U.S. Bureau of Labor Statistics (BLS) released its Job Openings and Labor Turnover Survey (JOLTS) report for July 2022. The report indicated that the U.S. labor market remained very strong, even though, according to the Bureau of Economic Analysis (BEA), real gross domestic product (GDP) had declined during the first half of 2022. (In this blog post, we discuss the possibility that during this period the real GDP data may have been a misleading indicator of the actual state of the economy.)
As the following figure shows, the rate of job openings remained very high, even in comparison with the strong labor market of 2019 and early 2020 before the Covid-19 pandemic began disrupting the U.S. economy. The BLS defines a job opening as a full-time or part-time job that a firm is advertising and that will start within 30 days. The rate of job openings is the number of job openings divided by the number of job openings plus the number of employed workers, multiplied by 100.
In the following figure, we compare the total number of job openings to the total number of people unemployed. The figure shows that in July 2022 there were almost two jobs available for each person who was unemployed.
Typically, a strong job market with high rates of job openings indicates that firms are expanding and that they expect their profits to be increasing. As we discuss in Macroeconomics, Chapter 6, Section 6.2 (Microeconomics and Economics, Chapter 8, Section 8.2) the price of a stock is determined by investors’ expectations of the future profitability of the firm issuing the stock. So, we might have expected that on the day the BLS released the July JOLTS report containing good news about the labor market, the stock market indexes like the Dow Jones Industrial Average, the S&P 500, and the Nasdaq Composite Index would rise. In fact, though the indexes fell, with the Dow Jones Industrial Average declining a substantial 300 points. As a column in the Wall Street Journal put it: “A surprisingly tight U.S. labor market is rotten news for stock investors.” Why did good news about the labor market could cause stock prices to decline? The answer is found in investors’ expectations of the effect the news would have on monetary policy.
In August 2022, Fed Chair Jerome Powell and the other members of the Federal Reserve Open Market Committee (FOMC) were in the process of tightening monetary policy to reduce the very high inflation rates the U.S. economy was experiencing. In July 2022, inflation as measured by the percentage change in the consumer price index (CPI) was 8.5 percent. Inflation as measured by the percentage change in the personal consumption expenditures (PCE) price index—which is the measure of inflation that the Fed uses when evaluating whether it is hitting its target of 2 percent annual inflation—was 6.3 percent. (For a discussion of the Fed’s choice of inflation measure, see the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline,” in Macroeconomics, chapter 15, Section 15.5 and in Economics, Chapter 25, Section 25.5.)
To slow inflation, the FOMC was increasing its target for the federal funds rate—the interest rate that banks charge each other on overnight loans—which in turn was leading to increases in other interest rates, such as the interest rate on residential mortgage loans. Higher interest rates would slow increases in aggregate demand, thereby slowing price increases. How high would the FOMC increase its target for the federal funds rate? Fed Chair Powell had made clear that the FOMC would monitor economic data for indications that economic activity was slowing. Members of the FOMC were concerned that unless the inflation rate was brought down quickly, the U.S. economy might enter a wage-price spiral in which high inflation rates would lead workers to push for higher wages, which, in turn, would increase firms’ labor costs, leading them to raise prices further, in response to which workers would push for even higher wages, and so on. (We discuss the concept of a wage-price spiral in this earlier blog post.)
In this context, investors interpretated data showing unexpected strength in the economy—particularly in the labor market—as making it likely that the FOMC would need to make larger increases in its target for the federal fund rate. The higher interest rates go, the more likely that the U.S. economy will enter an economic recession. During recessions, as production, income, and employment decline, firms typically experience lower profits or even suffer losses. So, a good JOLTS report could send stock prices falling because news that the labor market was stronger than expected increased the likelihood that the FOMC’s actions would push the economy into a recession, reducing profits. Or as the Wall Street Journal column quoted earlier put it:
“So Tuesday’s [JOLTS] report was good news for workers, but not such good news for stock investors. It made another 0.75-percentage-point rate increase [in the target for the federal funds rate] from the Fed when policy makers meet next month seem increasingly likely, while also strengthening the case that the Fed will keep raising rates well into next year. Stocks sold off sharply following the report’s release.”
Sources: U.S. Bureau of Labor Statistics, “Job Openings and Labor Turnover–July 2022,” bls.gov, August 30, 2022; Justin Lahart, “Why Stocks Got Jolted,” Wall Street Journal, August 30, 2022; Jerome H. Powell, “Monetary Policy and Price Stability,” speech at “Reassessing Constraints on the Economy and Policy,” an economic policy symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming, August 26, 2022; and Federal Reserve Bank of St. Louis.
The Federal Reserve building in Washington, DC. Photo from the Wall Street Journal.
Four times per year, the members of the Federal Reserve’s Federal Open Market Committee (FOMC) publish their projections, or forecasts, of the values of the inflation rate, the unemployment, and changes in real gross domestic product (GDP) for the current year, each of the following two years, and for the “longer run.” The following table, released following the FOMC meeting held on March 15 and 16, 2022, shows the forecasts the members made at that time.
Median Forecast
Meidan Forecast
Median Forecast
2022
2023
2024
Longer run
Actual values, March 2022
Change in real GDP
2.8%
2.2%
2.2%
1.8%
3.5%
Unemployment rate
3.5%
3.5%
3.6%
4.0%
3.6%
PCE inflation
4.3%
2.7%
2.3%
2.0%
6.6%
Core PCE inflation
4.1%
2.6%
2.3%
No forecast
5.2%
Recall that PCE refers to the consumption expenditures price index, which includes the prices of goods and services that are in the consumption category of GDP. Fed policymakers prefer using the PCE to measure inflation rather than the consumer price index (CPI) because the PCE includes the prices of more goods and services. The Fed uses the PCE to measure whether it is hitting its target inflation rate of 2 percent. The core PCE index leaves out the prices of food and energy products, including gasoline. The prices of food and energy products tend to fluctuate for reasons that do not affect the overall long-run inflation rate. So Fed policymakers believe that core PCE gives a better measure of the underlying inflation rate. (We discuss the PCE and the CPI in the Apply the Concept “Should the Fed Worry about the Prices of Food and Gasoline?” in Macroeconomics, Chapter 15, Section 15.5 (Economics, Chapter 25, Section 25.5)).
The values in the table are the median forecasts of the FOMC members, meaning that the forecasts of half the members were higher and half were lower. The members do not make a longer run forecast for core PCE. The final column shows the actual values of each variable in March 2022. The values in that column represent the percentage in each variable from the corresponding month (or quarter in the case of real GDP) in the previous year. Links to the FOMC’s economic projections can be found on this page of the Federal Reserve’s web site.
At its March 2022 meeting, the FOMC began increasing its target for the federal funds rate with the expectation that a less expansionary monetary policy would slow the high rates of inflation the U.S. economy was experiencing. Note that in that month, inflation measured by the PCE was running far above the Fed’s target inflation rate of 2 percent.
In raising its target for the federal funds rate and by also allowing its holdings of U.S. Treasury securities and mortgage-backed securities to decline, Fed Chair Jerome Powell and the other members of the FOMC were attempting to achieve a soft landing for the economy. A soft landing occurs when the FOMC is able to reduce the inflation rate without causing the economy to experience a recession. The forecast values in the table are consistent with a soft landing because they show inflation declining towards the Fed’s target rate of 2 percent while the unemployment rate remains below 4 percent—historically, a very low unemployment rate—and the growth rate of real GDP remains positive. By forecasting that real GDP would continue growing while the unemployment rate would remain below 4 percent, the FOMC was forecasting that no recession would occur.
Some economists see an inconsistency in the FOMC’s forecasts of unemployment and inflation as shown in the table. They argued that to bring down the inflation rate as rapidly as the forecasts indicated, the FOMC would have to cause a significant decline in aggregate demand. But if aggregate demand declined significantly, real GDP would either decline or grow very slowly, resulting in the unemployment rising above 4 percent, possibly well above that rate. For instance, writing in the Economist magazine, Jón Steinsson of the University of California, Berkeley, noted that the FOMC’s “combination of forecasts [of inflation and unemployment] has been dubbed the ‘immaculate disinflation’ because inflation is seen as falling rapidly despite a very tight labor market and a [federal funds] rate that is for the most part negative in real terms (i.e., adjusted for inflation).”
Similarly, writing in the Washington Post, Harvard economist and former Treasury secretary Lawrence Summers noted that “over the past 75 years, every time inflation has exceeded 4 percent and unemployment has been below 5 percent, the U.S. economy has gone into recession within two years.”
In an interview in the Financial Times, Olivier Blanchard, senior fellow at the Peterson Institute for International Economics and former chief economist at the International Monetary Fund, agreed. In their forecasts, the FOMC “had unemployment staying at 3.5 percent throughout the next two years, and they also had inflation coming down nicely to two point something. That just will not happen. …. [E]ither we’ll have a lot more inflation if unemployment remains at 3.5 per cent, or we will have higher unemployment for a while if we are actually to inflation down to two point something.”
While all three of these economists believed that unemployment would have to increase if inflation was to be brought down close to the Fed’s 2 percent target, none were certain that a recession would occur.
What might explain the apparent inconsistency in the FOMC’s forecasts of inflation and unemployment? Here are three possibilities:
Fed policymakers are relatively optimistic that the factors causing the surge in inflation—including the economic dislocations due to the Covid-19 pandemic and the Russian invasion of Ukraine and the surge in federal spending in early 2021—are likely to resolve themselves without the unemployment rate having to increase significantly. As Steinsson puts it in discussing this possibility (which he believes to be unlikely) “it is entirely possible that inflation will simply return to target as the disturbances associated with Covid-19 and the war in Ukraine dissipate.”
Fed Chair Powell and other members of the FOMC were convinced that business managers, workers, and investors still expected that the inflation rate would return to 2 percent in the long run. As a result, none of these groups were taking actions that might lead to a wage-price spiral. (We discussed the possibility of a wage-price spiral in earlier blog post.) For instance, at a press conference following the FOMC meeting held on May 3 and 4, 2022, Powell argued that, “And, in fact, inflation expectations [at longer time horizons] come down fairly sharply. Longer-term inflation expectations have been reasonably stable but have moved up to—but only to levels where they were in 2014, by some measures.” If Powell’s assessment was correct that expectations of future inflation remained at about 2 percent, the probability of a soft landing was increased.
We should mention the possibility that at least some members of the FOMC may have expected that the unemployment rate would increase above 4 percent—possibly well above 4 percent—and that the U.S. economy was likely to enter a recession during the coming months. They may, however, have been unwilling to include this expectation in their published forecasts. If members of the FOMC state that a recession is likely, businesses and households may reduce their spending, which by itself could cause a recession to begin.
Sources: Martin Wolf, “Olivier Blanchard: There’s a for Markets to Focus on the Present and Extrapolate It Forever,” ft.com, May 26, 2022; Lawrence Summers, “My Inflation Warnings Have Spurred Questions. Here Are My Answers,” Washington Post, April 5, 2022; Jón Steinsson, “Jón Steinsson Believes That a Painless Disinflation Is No Longer Plausible,” economist.com, May 13, 2022; Federal Open Market Committee, “Summary of Economic Projections,” federalreserve.gov, March 16, 2022; and Federal Open Market Committee, “Transcript of Chair Powell’s Press Conference May 4, 2022,” federalreserve.gov, May 4, 2022.
On Thursday morning, April 28, the Bureau of Economic Analysis (BEA) released its “advance” estimate for the change in real GDP during the first quarter of 2022. As shown in the first line of the following table, somewhat surprisingly, the estimate showed that real GDP had declined by 1.4 percent during the first quarter. The Federal Reserve Bank of Atlanta’s “GDP Now” forecast had indicated that real GDP would increase by 0.4 percent in the first quarter. Earlier in April, the Wall Street Journal’s panel of academic, business, and financial economists had forecast an increase of 1.2 percent. (A subscription may be required to access the forecast data from the Wall Street Journal’s panel.)
Do the data on real GDP from the first quarter of 2022 mean that U.S. economy may already be in recession? Not necessarily, for several reasons:
First, as we note in the Apply the Concept, “Trying to Hit a Moving Target: Making Policy with ‘Real-Time’ Data,” in Macroeconomics, Chapter 15, Section 15.3 (Economics, Chapter 25, Section 25.3): “The GDP data the BEA provides are frequently revised, and the revisions can be large enough that the actual state of the economy can be different for what it at first appears to be.”
Second, even though business writers often define a recession as being at least two consecutive quarters of declining real GDP, the National Bureau of Economic Research has a broader definition: “A recession is a significant decline in activity across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.” Particularly given the volatile movements in real GDP during and after the pandemic, it’s possible that even if real GDP declines during the second quarter of 2022, the NBER might not decide to label the period as being a recession.
Third, and most importantly, there are indications in the underlying data that the U.S. economy performed better during the first quarter of 2022 than the estimate of declining real GDP would indicate. In a blog post in January discussing the BEA’s advance estimate of real GDP during the fourth quarter of 2021, we noted that the majority of the 6.9 percent increase in real GDP that quarter was attributable to inventory accumulation. The earlier table indicates that the same was true during the first quarter of 2022: 60 percent of the decline in real GDP during the quarter was the result of a 0.84 decline in inventory investment.
We don’t know whether the decline in inventories indicates that firms had trouble meeting demand for goods from current inventories or whether they decided to reverse some of the increases in inventories from the previous quarter. With supply chain disruptions continuing as China grapples with another wave of Covid-19, firms may be having difficulty gauging how easily they can replace goods sold from their current inventories. Note the corresponding point that the decline in sales of domestic product (line 2 in the table) was smaller than the decline in real GDP.
The table below shows changes in the components of real GDP. Note the very large decline exports and in purchases of goods and services by the federal government. (Recall from Macroeconomics, Chapter 16, Section 16.1, the distinction between government purchases of goods and services and total government expenditures, which include transfer payments.) The decline in federal defense spending was particularly large. It seems likely from media reports that the escalation of Russia’s invasion of Ukraine will lead Congress and President Biden to increase defense spending.
Notice also that increases in the non-government components of aggregate demand remained fairly strong: personal consumption expenditures increased 2.7 percent, gross private domestic investment increased 2.3 percent, and imports surged by 17.7 percent. These data indicate that private demand in the U.S. economy remains strong.
So, should we conclude that the economy will shrug off the decline in real GDP during the first quarter and expand during the remainder of the year? Unfortunately, there are still clouds on the horizon. First, there are the difficult to predict effects of continuing supply chain problems and of the war in Ukraine. Second, the Federal Reserve has begun tightening monetary policy. Whether Fed Chair Jerome Powell will be able to bring about a soft landing, slowing inflation significantly while not causing a large jump in unemployment, remains the great unknown of economic policy. Finally, if high inflation rates persist, households and firms may respond in ways that are difficult to predict and, may, in particular decide to reduce their spending from the current strong levels.
It now seems clear that the new monetary policy strategy the Fed announced in August 2020 was a decisive break with the past in one respect: With the new strategy, the Fed abandoned the approach dating to the 1980s of preempting inflation. That is, the Fed would no longer begin raising its target for the federal funds rate when data on unemployment and real GDP growth indicated that inflation was likely to rise. Instead, the Fed would wait until inflation had already risen above its target inflation rate.
Since 2012, the Fed has had an explicit inflation target of 2 percent. As we discussed in a previous blog post, with the new monetary policy the Fed announced in August 2020, the Fed modified how it interpreted its inflation target: “[T]he Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
The Fed’s new approach is sometimes referred to as average inflation targeting (AIT) because the Fed attempts to achieve its 2 percent target on average over a period of time. But as former Fed Vice Chair Richard Clarida discussed in a speech in November 2020, the Fed’s monetary policy strategy might be better called a flexible average inflation target (FAIT) approach rather than a strictly AIT approach. Clarida noted that the framework was asymmetric, meaning that inflation rates higher than 2 percent need not be offset with inflation rates lower than 2 percent: “The new framework is asymmetric. …[T]he goal of monetary policy … is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent.” And: “Our framework aims … for inflation to average 2 percent over time, but it does not make a … commitment to achieve … inflation outcomes that average 2 percent under any and all circumstances ….”
Inflation began to increase rapidly in mid-2021. The following figure shows three measure of inflation, each calculated as the percentage change in the series from the same month in the previous year: the consumer price index (CPI), the personal consumption expenditure (PCE) price index, and the core PCE—which excludes the prices of food and energy. Inflation as measured by the CPI is sometimes called headline inflation because it’s the measure of inflation that most often appears in media stories about the economy. The PCE is a broader measure of the price level in that it includes the prices of more consumer goods and services than does the CPI. The Fed’s target for the inflation rate is stated in terms of the PCE. Because prices of food and inflation fluctuate more than do the prices of other goods and services, members of the Fed’s Federal Open Market Committee (FOMC) generally consider changes in the core PCE to be the best measure of the underlying rate of inflation.
The figure shows that for most of the period from 2002 through early 2021, inflation as measured by the PCE was below the Fed’s 2 percent target. Since that time, inflation has been running well above the Fed’s target. In February 2022, PCE inflation was 6.4 percent. (Core PCE inflation was 5.4 percent and CPI inflation was 7.9 percent.) At its March 2022 meeting the FOMC begin raising its target for the federal funds rate—well after the increase in inflation had begun. The Fed increased its target for the federal funds rate by 0.25 percent, which raised the target from 0 to 0.25 percent to 0.25 to 0.50 percent.
Should the Fed have taken action to reduce inflation earlier? To answer that question, it’s first worth briefly reviewing Fed policy during the Great Inflation of 1968 to 1982. In the late 1960s, total federal spending grew rapidly as a result of the Great Society social programs and the war in Vietnam. At the same time, the Fed increased the rate of growth of the money supply. The result was an end to the price stability of the 1952-1967 period during which the annual inflation rate had averaged only 1.6 percent.
The 1973 and 1979 oil price shocks also contributed to accelerating inflation. Between January 1974 and June 1982, the annual inflation rate averaged 9.3 percent. This was the first episode of sustained inflation outside of wartime in U.S. history—until now. Although the oil price shocks and expansionary fiscal policy contributed to the Great Inflation, most economists, inside and outside of the Fed, eventually concluded that Fed policy failures were primarily responsible for inflation becoming so severe.
The key errors are usually attributed to Arthur Burns, who was Fed Chair from January 1970 to March 1978. Burns, who was 66 at the time of his appointment, had made his reputation for his work on business cycles, mostly conducted prior to World War II at the National Bureau of Economic Research. Burns was skeptical that monetary policy could have much effect on inflation. He was convinced that inflation was mainly the result of structural factors such as the power of unions to push up wages or the pricing power of large firms in concentrated industries.
Accordingly, Burns was reluctant to raise interest rates, believing that doing so hurt the housing industry without reducing inflation. Burns testified to Congress that inflation “poses a problem that traditional monetary and fiscal remedies cannot solve as quickly as the national interest demands.” Instead of fighting inflation with monetary policy he recommended “effective controls over many, but by no means all, wage bargains and prices.” (A collection Burns’s speeches can be found here.)
Few economists shared Burns’s enthusiasm for wage and price controls, believing that controls can’t end inflation, they can only temporarily reduce it while causing distortions in the economy. (A recent overview of the economics of price controls can be found here.) In analyzing this period, economists inside and outside the Fed concluded that to bring the inflation rate down, Burns should have increased the Fed’s target for the federal funds rate until it was higher than the inflation rate. In other words, the real interest rate, which equals the nominal—or stated—interest rate minus the inflation rate, needed to be positive. When the real interest rate is negative, a business may, for example, pay 6% on a bond when the inflation rate is 10%, so they’re borrowing funds at a real rate of −4%. In that situation, we would expect borrowing to increase, which can lead to a boom in spending. The higher spending worsens inflation.
Because Burns and the FOMC responded only slowly to rising inflation, workers, firms, and investors gradually increased their expectations of inflation. Once higher expectation inflation became embedded, or entrenched, in the U.S. economy it was difficult to reduce the actual inflation rate without increasing the target for the federal funds rate enough to cause a significant slowdown in the growth of real GDP and a rise in the unemployment rate. As we discuss in Macroeconomics, Chapter 17, Sections 17.2 and 17.3 (Economics, Chapter 27, Sections 27.2 and 27.3), the process of the expected inflation rate rising over time to equal the actual inflation rate was first described in research conducted separately by Nobel Laureates Milton Friedman and Edmund Phelps during the 1960s.
An implication of Friedman and Phelps’s work is that because a change in monetary policy takes more than a year to have its full effect on the economy, if the Fed waits until inflation has already increased, it will be too late to keep the higher inflation rate from becoming embedded in interest rates and long-term labor and raw material contracts.
Paul Volcker, appointed Fed chair by Jimmy Carter in 1979, showed that, contrary to Burns’s contention, monetary policy could, in fact, deal with inflation. By the time Volcker became chair, inflation was above 11%. By raising the target for the federal funds rate to 22%—it was 7% when Burns left office—Volcker brought the inflation rate down to below 4%, but only at the cost of a severe recession during 1981–1982, during which the unemployment rate rose above 10 percent for the first time since the Great Depression of the 1930s. Note that whereas Burns had largely failed to increase the target for the federal funds as rapidly as inflation had increased—resulting in a negative real federal funds rate—Volcker had raised the target for the federal funds rate above the inflation rate—resulting in a positive real federal funds rate.
Because the 1981–1982 recession was so severe, the inflation rate declined from above 11 percent to below 4 percent. In Chapter 17, Figure 17.10 (reproduced below), we plot the course of the inflation and unemployment rates from 1979 to 1989.
Caption: Under Chair Paul Volcker, the Fed began fighting inflation in 1979 by reducing the growth of the money supply, thereby raising interest rates. By 1982, the unemployment rate had risen to 10 percent, and the inflation rate had fallen to 6 percent. As workers and firms lowered their expectations of future inflation, the short-run Phillips curve shifted down. The adjustment in expectations allowed the Fed to switch to an expansionary monetary policy, which by 1987 brought unemployment back to the natural rate of unemployment, with an inflation rate of about 4 percent. The orange line shows the actual combinations of unemployment and inflation for each year from 1979 to 1989.
The Fed chairs who followed Volcker accepted the lesson of the 1970s that it was important to head off potential increases in inflation before the increases became embedded in the economy. For instance, in 2015, then Fed Chair Janet Yellen in explaining why the FOMC was likely to raise to soon its target for the federal funds rate noted that: “A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten. It is largely for this reason that a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.”
Between 2015 and 2018, the FOMC increased its target for the federal funds rate nine times, raising the target from a range of 0 to 0.25 percent to a range of 2.25 to 2.50 percent. In 2018, Raphael Bostic, president of the Federal Reserve Bank of Atlanta justified these rate increases by noting that “… we shouldn’t forget that [the Fed’s] credibility [with respect to keeping inflation low] was hard won. Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so.”
He used the following figure to illustrate his point.
Bostic interpreted the figure as follows:
“[The red areas in the figure are] periods of time when the actual unemployment rate fell below what the U.S. Congressional Budget Office now estimates as the so-called natural rate of unemployment. I refer to these episodes as “high-pressure” periods. Here is the punchline. Dating back to 1960, every high-pressure period ended in a recession. And all but one recession was preceded by a high-pressure period….
I think a risk management approach requires that we at least consider the possibility that unemployment rates that are lower than normal for an extended period are symptoms of an overheated economy. One potential consequence of overheating is that inflationary pressures inevitably build up, leading the central bank to take a much more “muscular” stance of policy at the end of these high-pressure periods to combat rising nominal pressures. Economic weakness follows [resulting typically, as indicated in the figure by the gray band, in a recession].”
By July 2019, a majority of the members of the FOMC, including Chair Powell, had come to believe that with no sign of inflation accelerating, they could safely cut the federal funds rate. But they had not yet explicitly abandoned the view that the FOMC should act to preempt increases in inflation. The formal change came in August 2020 when, as discussed earlier, the FOMC announced the new FAIT.
At the time the FOMC adopted its new monetary policy strategy, most members expected that any increase in inflation owing to problems caused by the Covid-19 pandemic—particularly the disruptions in supply chains—would be transitory. Because inflation has proven to be more persistent than Fed policymakers and many economists expected, two aspects of the FAIT approach to monetary policy have been widely discussed: First, the FOMC did not explicitly state by how much inflation can exceed the 2 percent target or for how long it needs to stay there before the Fed will react. The failure to elaborate on this aspect of the policy has made it more difficult for workers, firms, and investors to gauge the Fed’s likely reaction to the acceleration in inflation that began in the spring of 2021. Second, the FOMC’s decision to abandon the decades-long policy of preempting inflation may have made it more difficult to bring inflation down to the 2 percent target without causing a recession.
Federal Reserve Governor Lael Brainard recently remarked that “it is of paramount importance to get inflation down” and some Fed policymakers believe that the FOMC will have to begin increasing its target for the federal funds rate more aggressively. (The speech in which Governor Brainard discusses her current thinking on monetary policy can be found here.) For instance James Bullard, president of the Federal Reserve Bank of St. Louis, has argued in favor of raising the target to above 3 percent this year. With the Fed’s preferred measure of inflation running above 5 percent, it would take substantial increases int the target to achieve a positive real federal funds rate.
It is an open question whether Jerome Powell finds himself in a position similar to that of Paul Volcker in 1979: Rapid increases in interest rates may be necessary to keep inflation from accelerating, but doing so risks causing a recession. In a recent speech (found here), Powell pledged that: “We will take the necessary steps to ensure a return to price stability. In particular, if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
But Powell argued that the FOMC could achieve “a soft landing, with inflation coming down and unemployment holding steady” even if it is forced to rapidly increase its target for the federal funds rate:
“Some have argued that history stacks the odds against achieving a soft landing, and point to the 1994 episode as the only successful soft landing in the postwar period. I believe that the historical record provides some grounds for optimism: Soft, or at least softish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.”
Some economists have been skeptical that a soft landing is likely. Harvard economist and former Treasury Secretary Lawrence Summers has been particularly critical of Fed policy, as in this Twitter thread. Summers concludes that: “I am apprehensive that we will be disappointed in the years ahead by unemployment levels, inflation levels, or both.” (Summers and Harvard economist Alex Domash provide an extended discussion in a National Bureau of Economic Research Working Paper found here.)
Clearly, we are in a period of great macroeconomic uncertainty.
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