Clarida is Right; Now Isn't the Time to Tighten

In an interview on CNBC's Closing Bell last week, Federal Reserve Vice Chairman Richard Clarida made clear to viewers that now isn't the time to begin tapering the Fed's easing policies and certainly not the time to consider an overall tightening by raising the policy rate above its current range of 0-25 basis points.

With inflation concerns occupying the majority of economic discourse, Clarida maintained the Federal Open Market Committee’s (FOMC) wait-and-see policy approach by saying, "We’re still a long way from our goals, and in our new framework, we want to see actual progress and not just forecast progress...and we are not there yet."

This couldn't be more accurate or a more prudent policy approach. We have no idea what is around the corner with regard to how this pandemic will play out or how it will impact our economy over the medium-term. It would be injudicious for the FOMC to prioritize inflation forecasts—even the Fed's own forecasts—above prime-age female labor force participation, prime-age male unemployment, and small business balance sheet health. Each is still very shaky, and we don't want to jeopardize recent improvements in these areas for a fear that inflation will get out of control.

Notice I underlined "new" in Clarida's above statement. There still seems to be a widespread misunderstanding—most notably by the financial press and the old guard on Wall Street—of the Fed's new inflation policy. We no longer live in the simplistic, 2% inflation targeting world where policymakers use the Taylor Rule to decide whether to raise or lower interest rates. Today’s mandate is quite different, yet many still believe the Fed is operating under the old 2% target.

(The Taylor Rule, in its most simplified form, states that if inflation sits below the target rate [2% here in the US], policymakers should lower rates to drive inflation upwards, and if inflation is above the target, policymakers should raise rates—i.e., tighten—to drive inflation lower.)

While established just nine years ago, the formal inflation target of 2% has already become an antiquated policy measure within the halls of America's central bank. When the pandemic hit last year and the Fed discovered it needed more firepower to fight Covid-19, officials ditched the old approach and put in the new rule which targets average inflation.

I wrote about the new rule back in September 2020. My take was that while the new approach was a veritable rule change—moving the FOMC from targeting 2% inflation to 2% average inflation—it should be received as a welcome policy adjustment because it would afford FOMC members more professional discretion in setting interest rates. In addition, it would better equip them in not only achieving 2% inflation but maintaining that target over the medium term—neither of which the FOMC has been able to accomplish since the inception of the 2% target in 2012. What I didn't expect was how much the general public would misinterpret the new rule and the actions the Fed would need to take in order to satisfy the new framework. This is a failure of the economics profession, and of me personally. It is our responsibility as economists to not only analyze economic data but also educate the public in what the data mean and what they should expect their leaders to do with that data. In that regard, we dropped the ball. So to rectify this, I think it would be constructive to look at what the new framework means for recent price-level increases and how the FOMC should respond.

Across most sectors of the economy, there has been noticeable upward price pressure over the last few months. The data coming in are irrefutable in this regard. However, the reason Vice Chairman Clarida—and many other Fed governors and regional branch presidents—think it's too early to taper long-dated asset purchases or raise short term interest rates is because the new rule says it's too early. Average inflation of 2%, which is what the FOMC now targets, is nowhere near 2%. Most likely, it will take many months of inflation above 2% for that goal to be achieved—which is what Federal Reserve Chairman Jerome Powell touched on in his 60 Minutes interview earlier this year. We just aren't there yet.

Having said that, just because we aren't "there" yet doesn't mean the FOMC will let inflation get out of control and the US will suddenly slip back to 1970s-level inflation. The Fed won't let that happen. There are still too many inflation hawks on the FOMC, and even if the Fed were to fall asleep at the wheel, failing to raise rates when a rate increase is called for, we would need multiple supply shocks, like those seen in the '70s, to accompany Fed lethargy for the US economy to witness anything close to 1970s-level inflation.

A bigger threat, and what is likely more concerning to those on the FOMC than runaway inflation, is raising rates too soon. Our current recovery is fragile. Forget Wall Street's 10% growth forecasts. Forget the Biden Administration's estimates of new jobs created in 2021. Each of those estimates are based on assumptions that the Fed will remain accommodative throughout this year and most of 2022. The Fed has done a phenomenal job keeping its Forward Guidance—its communication of future interest rate policy—simple and clear: telling markets, investors, and other policymakers that they intend to keep rates steady for the next 18 months. But if the Fed were to suddenly change course by tapering asset purchases or raising rates, each of the aforementioned forecasts would adjust substantially.

Bottom line: policymakers at the Fed aren't going to risk jeopardizing this recovery. Should they keep an eye on inflation? Certainly. Is now the time to begin raising rates to combat future inflation when we have yet to meet our inflation target? Absolutely not.