Why the Fed shouldn’t stop worrying about inflation
At the recent central-bank symposium at Jackson Hole, Federal Reserve Chairman Jerome Powell delivered a widely expected message on interest rates: “The time has come for policy to adjust.” He all but confirmed that the Fed would cut rates by at least a quarter-point when its policymakers next meet in September.
A modest cut makes sense. Inflation remains a little above target but continues to subside — and thanks to a cooler labor market, a lower policy rate would suffice to maintain gentle downward pressure on prices. That said, one of the points Powell made in his address deserves emphasis. Over the coming months, the biggest mistake the central bank could make would be to let investors think its attention is shifting away from inflation.
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The Fed has a dual mandate — price stability and maximum employment — and needs to maintain equal weight on both. As Powell said, the upside risk on inflation has diminished and the downside risk on employment has increased. That dictates a policy adjustment, but this shouldn’t be construed as unduly prioritizing employment over inflation. A shift in the balance of risks is not the same as a shift in the importance attached to each goal.
This is no mere semantic distinction. Powell’s speech drew attention to what’s at stake if the Fed is suspected of setting its inflation goal aside.
He asked: How did the Fed succeed in suppressing inflation without tanking the economy? His main answer was that in tightening policy decisively (albeit belatedly) in the spring of 2022, the central bank affirmed its commitment to a 2% inflation target — which, in turn, kept expectations anchored. As a result, the central bank’s preferred measure of underlying inflation stood at 2.6% in June, down from its peak of 5.6% in 2022, with (as yet) no substantial increase in unemployment, much less an outright recession. If the Fed had let expectations rise, a recession might very well have been necessary to get prices under control.
The task of managing these expectations is complicated by the appetite of investors and analysts for momentous turning-points — that is, for seeing policy adjustments as shifts from one regime to another, as opposed to being dictated by a single consistent approach. Central banks, anxious not to take investors by surprise, sometimes aggravate this problem by suggesting that a change in interest rates commits them to further changes over the next year or more. This helps explain why the Fed chose not to raise rates in the second half of 2021, and perhaps why it decided not to cut them at its meeting last month: In both cases, the evidence supported a change in rates, but not firmly enough to justify an entirely new path.
There’s a lot to be said for changing rates more readily in response to new data while avoiding promises, real or imagined, about what happens later. The commitment should be to the central bank’s goals, not to a schedule for future policy. Lately Powell and his colleagues have edged in this direction, putting less weight on “forward guidance” and more on “data dependence” in service of the dual mandate. That’s wise. As things stand, a small cut in interest rates is warranted. Whether it should be 0.25% or 0.50% can wait for new information on prices and jobs that will be released between now and next month’s meeting. After that, whether rates fall, rise or stay the same should depend on the data.
— Bloomberg Opinion
