The stock market applauded Federal Reserve Chairman Jerome Powell’s testimony to Congress last Tuesday, rebounding on his assurance that an increase in interest rates is nowhere in sight. Powell’s message was well-grounded as well as reassuring — but there’s no disguising the challenges that lie ahead for monetary policy.
Investors were concerned that the recent rise in bond yields and growing interest in the outlook for inflation would cause Powell to modify his previous commitment to extended monetary accommodation. He didn’t waver. “The economy is a long way from our employment and inflation goals,” he said. It will take “some time for substantial further progress to be achieved.” He also underlined two important parts of the Fed’s current posture: It “will not tighten monetary policy solely in response to a strong labor market,” and “Appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”
Powell was right to give no hint that the Fed’s policy is about to shift. Inflation is still too low and unemployment still too high. Both he and Treasury Secretary Janet Yellen have been at pains lately to point out that the standard measure of unemployment — currently 6.3% — seriously understates the true count of joblessness, because it ignores people who’ve given up looking for work. As the economy recovers, these so-called discouraged workers are likely to rejoin the labor force at higher rates than after ordinary recessions. A broader measure of unemployment adds them to the total, to give a better gauge of spare capacity. It stands at roughly 10%. The economy is still a very long way from overheating.
True, the accelerating pace of vaccinations has raised hopes that the pandemic is coming under control. This, together with the prospect of further fiscal stimulus and continued monetary accommodation, has raised expected inflation a little. The same goes for the small rise in bond yields. Both are signs of progress, not signals that the Fed needs to adjust.
Yet this shouldn’t disguise the dilemma that lies ahead for the central bank, and the risks surrounding the outlook.
One telling disconnect in the Fed’s statements concerns fiscal policy. Last year, it emphasized the need for stronger fiscal stimulus: The Fed couldn’t do it all, Powell rightly said. Now, with more than $3 trillion of support already arranged and another $1.9 trillion in the pipeline, the Fed is reluctant to be drawn on how much is enough. Its virtually unbounded commitment to easy monetary policy isn’t contingent on the outlook for fiscal policy — even though judging the appropriate stance of monetary policy can’t be done in isolation.
This is a subject the Fed would prefer to avoid today and for as long as possible, but another huge fiscal package will inevitably bring forward the point at which it needs to raise interest rates. Moving away from its current policy without causing a financial-market tantrum won’t be easy. And persisting with its present stance even after clear signs of overheating have emerged won’t be easy, either.
The underlying problem is that budgets and interest rates need to work in tandem. The question of explicit Fed-Treasury coordination and the proper roles of monetary and fiscal policy was pressing even before the pandemic, thanks to the persistence of very low interest rates and the prospect of so-called secular stagnation. The extraordinary demands on economic policy during this emergency, and the pandemic’s legacy of inflated asset prices and expanded public debt, will bring it center stage.
At some point the question of central bank independence will refuse to be ignored any longer.
— Bloomberg Opinion
