Federal Reserve Stands Pat: Is It Policy or Politics?

Federal Reserve Chairman Jerome Powell testifies before a U.S. Senate Banking, Housing, and Urban Affairs Committee hearing on “The Semiannual Monetary Policy Report to the Congress” on Capitol Hill in Washington, on March 7, 2023. Kevin Lamarque/Reuters

Commentary

The Federal Reserve’s recent decision to keep rates steady and to continue quantitative tightening (QT) at its current pace could be considered Chairman Jerome Powell’s in-kind contribution to a Joe Biden 2024 political action committee. The more cynical among us might consider it a capitulation to politics over inflation, at least for the time being.

A few things should be considered before delving into this:

• First, the Fed’s announcement on Dec. 13 that it would hold rates steady and the implications for rate cuts in 2024 that some analysts drew from the Fed’s “dot-plots” (i.e., its Summary of Economy Projections). The said announcement signaled that Mr. Powell and his colleagues will maintain liquidity, even as their own projections of inflation in 2024 exceed the 2 percent core inflation target by 40 basis points (i.e., at 2.4 percent).
• Second, the Fed’s decision weakened the U.S. Dollar Index, a measure of the value of the dollar relative to a basket of other currencies, to its lowest value since August. This will make imported products more expensive, exacerbating inflation.
• Third, small, medium, and regional banks that bought Treasurys to hold their reserves during the period of low interest rates have been battered by the spate of increasing interest rates because bond values move inversely with interest rates. Continued hikes risked many of them having to take additional measures to meet their reserve requirements or face a Silicon Valley Bank-style collapse.

The Fed’s Dual Mandate

Congress originally authorized the Fed to maintain stable prices and then, years later, full employment. But the mandate didn’t include the necessity to “avoid a recession.” Indeed, while the full employment mandate can be detrimentally affected by a recession, the two aren’t directly correlated, as shown in this chart showing unemployment and gross domestic product—the traditional assessment of a recession is two consecutive quarters of negative GDP.

Nevertheless, “avoiding a recession”—or achieving a so-called “soft landing”—seems to have been an overwhelming concern of the Fed since March 2022, when it started raising rates.

Most recently, the Fed’s preferred measure of inflation, the so-called “PCE core inflation price index,” a measure of personal consumption expenditures, has increased by 3.2 percent on an annual basis, well above the Fed’s 2 percent target rate. But the Fed has rationalized that the rate of inflation in the past six months is just 1.9 percent, according to figures released on Dec. 22.

So, anticipating a fall in core inflation, the Fed has been less aggressive in its rate hikes in its past three meetings, electing to “stand pat” and to keep its overnight rate at 5.25 percent to 5.5 percent and to maintain its rate of quantitative tightening at about $75 billion per month. The Consumer Price Index, so-called “headline” inflation, a separate measure compiled by the Department of Labor Statistics, remains at 3.1 percent, or quite high, even as falling prices for food and fuel drove the core inflation number lower.

Working at Cross Purposes

Milton Friedman, the late U.S. Nobel laureate in economics who rose to national fame in the 1970s and 80s, once told an audience in India in 1963 that “inflation is always and everywhere a monetary phenomenon,” meaning that it’s caused by the money supply exceeding the output of the economy. The Quantity Theory of Money bolsters his assertion, abbreviated “MV = PQ,” where M, the money supply, multiplied by V, the velocity of money (i.e., how often a dollar changes hands in a year) equals P, the price of goods times Q, the quantity of goods and services.

So, if the money supply, M, is increased, V is stable, and Q is the same, then P—prices—would necessarily have to increase. Likewise, if Q were to fall, P would increase, the other factors remaining equal. Friedman acknowledged that acute inflation could be caused by a dearth of products and services (as we experienced in the COVID-19 pandemic), so it wasn’t entirely “monetary,” per se, but that sustained, continued inflation was monetary. Both views about chronic and acute inflation are consistent, given MV=PQ.

Even as the Fed has worked, with admirable success, in some respects, to rein in inflation, the Biden administration has continued its spending, exacerbating inflation with continued pandemic-level spending, even as the COVID-19 pandemic has clearly faded. Failing to rein in spending and continuing it at near-pandemic levels is inherently inflationary because it maintains an elevated level of the money supply, M, with 1.7 trillion of it financed by debt.

Additionally, issues with Israel’s war with Hamas terrorists are likely to create shortfalls in Q, the quantity of goods, and the availability of services, particularly shipping. Terrorist missile attacks from groups allied with Hamas on ships in the Red Sea trying to transit the Suez Canal have caused shipping companies, as well as some oil companies, to divert around southern Africa and through the Strait of Gibraltar to reach European markets. Those higher shipping and oil costs (the latter of which is set globally) are bound to work themselves into the U.S. economy and may well arrest the decline in oil prices that has accounted for much of the decline in headline inflation.

Summary

It’s extremely important that the Fed remain vigilant on inflation and be willing to force the economy into recession, if necessary, to keep it restrained. Two-quarters of the average 1.9 percent inflation doesn’t constitute a trend, particularly as the Biden administration and Senate Democrats keep pushing for more and higher spending, seemingly unrestrained by the Republican House.

Moreover, given the extraordinary importance of falling fuel prices on the calculation of inflation, prognostications that the Fed may lower rates up to three times in 2024 are sanguine and have inordinately turbocharged the financial markets.

As always in an election year, but particularly given the extraordinary animus that the Washington establishment has for the leading Republican presidential contender, former President Donald Trump, Fed observers should be particularly circumspect about the Fed maintaining excess liquidity going into an election year.

While the Fed purports to be independent of politics, it’s extraordinarily naive to assume that’s entirely true.