Is the Fed Doing Too Much, Not Enough, or Just Right?
The Fed Reserve Chair Jerome Powell has an ongoing credibility problem. The problem is that markets, economists, and now Congress find him extremely credible. So credible that they have already declared him a winner fighting inflation, or of more pertinence, the economy a loser because Powell and the Fed policymakers have been so resolute in their fight against the rising cost of goods and services that soon there will be an abundance of newly unemployed, businesses will falter, and the stock market will be left in tatters. This view that he has already done too much and that the economy has been overkilled, even while it shows remarkable strength, was echoed many times during his visit to Capital Hill for his twice a year testimony.
“As of the end of December, there were 1.9 job openings for each unemployed individual, close to the all-time peak recorded last March, while unemployment insurance claims have remained near historic lows.” – Federal Reserve Chair Jay Powell (March 8, 2023).
Perhaps the most influential individual on financial markets in the U.S. and around the world, Fed Chair Powell continued his hawkish (inflation fighter, interest rate hiker) tone at his Senate and House testimonies. The overall message was; inflation is bad, inflation has been persistent, we will continue on the path to bring it down, also employment is incredibly strong, the employment situation is such that we can do more, we will do more to protect the U.S. economy from the ravages of inflation.
Powell began, “My colleagues and I are acutely aware that high inflation is causing significant hardship, and we are strongly committed to returning inflation to our 2 percent goal.” Powell discussed the forceful actions taken to date and added, “we have more work to do. Our policy actions are guided by our dual mandate to promote maximum employment and stable prices. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of labor market conditions that benefit all.”
Powell discussed the slowed growth last year; there were two periods of negative GDP growth reported during the first two quarters. He mentioned how the once red-hot housing sector is weakening under higher interest rates and that “Higher interest rates and slower output growth also appear to be weighing on business fixed investment.” He then discussed the impact on labor markets, “Despite the slowdown in growth, the labor market remains extremely tight. The unemployment rate was 3.4 percent in January, its lowest level since 1969. Job gains remained very strong in January, while the supply of labor has continued to lag.1 As of the end of December, there were 1.9 job openings for each unemployed individual, close to the all-time peak recorded last March, while unemployment insurance claims have remained near historic lows.”
On the subject of monetary policy, the head of the Federal Reserve mentioned that the target of 2% inflation has not been met and that recent numbers have it moving in the wrong direction. Powell also discussed that the Fed had raised short-term interest rates by adding 4.50%. He suggested that recent economic numbers require that an increase to where the sufficient height of fed funds peaks is likely higher than previously thought. All the while, he added, “we are continuing the process of significantly reducing the size of our balance sheet.”
Powell acknowledged some headway, “We are seeing the effects of our policy actions on demand in the most interest-sensitive sectors of the economy. It will take time, however, for the full effects of monetary restraint to be realized, especially on inflation. In light of the cumulative tightening of monetary policy and the lags with which monetary policy affects economic activity and inflation, the Committee slowed the pace of interest rate increases over its past two meetings.” Powell added, “We will continue to make our decisions meeting by meeting, taking into account the totality of incoming data and their implications for the outlook for economic activity and inflation.”
Questions and Answers
Congressmen both in the Senate and the House use the Semiannual Monetary Policy Report to Congress (formerly known as Humphrey Hawkins Testimony) to ask questions of the person with the most economic insight in Washington. Often their questions have already been covered in the Chair’s opening address, but Congresspeople will ask anyway to show their constituents at home that they are looking after them.
Elizabeth Warren is on the Senate Banking Committee; her math concluded the result of even a 1% increase in unemployment is a two million-worker job loss. Warren asked Powell, “Do you call laying off two million people this year not a sharp increase in unemployment?” “Explain that to the two million families who are going to be out of work.” In his response, Powell went back to historical numbers and reminded the Senator that an increase in unemployment would still rank the current economy above what Americans have lived through in most of our lifetimes, “We’re not, again, we’re not targeting any of that. But I would say even 4.5 percent unemployment is well better than most of the time for the last, you know, 75 years,” Chair Powell answered.
U.S. House Financial Services Committee on Wednesday heard Congressman Frank Lucas concerned about the pressure for the Fed to include climate concerns as an additional Fed mandate. Lucas from Oklahoma asked, “How careful are you in ensuring that the Fed does not place itself into the climate debate, and how can Congress ensure that the Fed’s regulatory tool kit is not warped into creating policy outcomes?” Powell answered that the Fed has a narrow but real role involving bank supervision. It’s important that individual banks understand and can manage over time their risks from any climate change and it’s impact on business and the economy. He wants to make sure the Fed never assumes a role where they are becoming a climate policymaker.
Other non-policy questions included Central Bank Digital Currencies. House Congressman Steven Lynch showed concerns that the Fed was experimenting with digital currencies. His question concerned receiving a public update on where they are with their partnership with MIT, their testing, and what they are trying to accomplish. Powell’s response seemed to satisfy the Congressman. “we engage with the public on an ongoing basis, we are also doing research on policy, and also technology,” said Powell. Follow-up questions on the architecture of a CBDC, were met with responses that indicated that the Fed, they are not at the stage of making decisions, instead, they are experimenting and learning. “How would this work, does it work, what is the best technology, what’s the most efficient.” Powell emphasized that the U.S. Federal Reserve is at an early stage, but making technological progress. They have not decided from a policy perspective if this is something that the country needs or desires.
Issues at Stake
As it relates to the stock and bond markets, the Fed has been holding overnight interest rates at a level that is more than one percentage point below the rate of inflation. The reality of this situation is that investors and savers that are earning near the Fed Funds rate on their deposits are losing buying power to the erosive effects of inflation. Those that are investing farther out on the yield curve are earning even less than overnight money. The impact here could be worse if inflation remains at current levels or higher, or better if the locked-in yields out longer on the curve are met with inflation coming down early on.
The Fed Chair indicated at the two testimony before both Houses of Congress that inflation has been surprisingly sticky. He also indicated that they might increase their expected stopping point on tightening credit. Interest rates out in the periods are actually lower than they had been in recent days and as much as 0.25% lower than they were last Fall. The lower market rates and inverted yield curve suggest the market thinks the Fed has already won and has likely gone too far. This thought process has made it difficult for the Fed Chair and others at the Fed that discuss a further need to throw cold water on an overheated economy. Fed Tightening has not led to an equal amount of upward movement out on the yield curve. This trust or expectation that the Fed has inflation under control would seem to be undermining the Fed’s efforts. With this, the Fed is likely to have to move even further to get the reaction it desires. The risk of an unwanted negative impact on the economy is heightened by the trust the bond market gives to Powell that he has this under control and may have already won.
Powell’s words are that the Fed has lost ground and has much more work to do.
At his semiannual testimony to Congress, an important message was sent to the markets. The Fed has the right tools to do the job of bringing inflation down to the 2% range, but those tools operate on the demand side. In the U.S. we are fortunate to have two jobs open for every person seeking employment. While this is inflationary, it provides policy with more options.
As of the reporting of January economic numbers, a trend may be beginning indicating the Fed is losing its fight against inflation. It is likely that it will have to do more, but the Fed stands willing to do what it takes. Powell ended his prepared address by saying, “Everything we do is in service to our public mission. We at the Federal Reserve will do everything we can to achieve our maximum-employment and price-stability goals.”
Managing Director, Channelchek