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: The Federal Reserve is in an impossible position, and now has yet another complicating factor


Elections are coming, making the Federal Reserve’s job all the more complicated.

The Fed has vowed not to let politics interfere with the making of good policy. But the central bank has two scheduled interest-rate decisions to make before elections in early November. The first of those is Wednesday; the second is Nov. 2.

In the past two meetings, the rate-setting Federal Open Market Committee (FOMC) boosted rates by a jumbo-sized 75 basis points to squash inflation. The central bank typically raises rates in 25-basis-point increments.

But the Fed would be in a better position to launch a reduced 50-basis-point rate hike in November, reflecting a step down in its activity, if it were to raise rates by 75 or even 100 basis points in September. Most economists are expecting a 75-basis-point increase Wednesday, with some awaiting 100 basis points.

If inflation continues to run hot — it was near a 40-year high of 8.3% in August — the Fed will face pressure to put up a big rate increase in early November just ahead of midterm elections. But if rates are already higher by then, policy might seem better poised to deal with that outcome.   

Setting the stage for November

The elections will be on Nov. 8. And the October employment report will be released on Nov. 4. A complicating factor has been that the labor market is extremely strong while inflation is very high.

This is a bit of a dizzy dance of important Fed moves and economic data ahead of elections that will have everyone watching the central bank and the economy. So the Fed’s actions now will set the stage for what it does in early November.

Right now, the policy gnomes are being pulled in different directions. Democratic economists including Alan Blinder and Peter Diamond are urging the Fed to go slow with policy to avoid recession. World Bank President David Malpass — he’s no Democrat — has similar concerns because his flock, the developing economies of the world, will be all the more imperiled if Fed rates go sharply higher, boosting the dollar and pressuring their economies in various ways.

On the flip side, St. Louis Fed President Jim Bullard is arguing for rapid rate hikes to get the fed funds up to around 4% and then pause. (The current target is 2.25%-2.50%.)

Bullard argues that going faster now is the best way to fight inflation and avoid a recession. He sees rapid increases to a pre-determined level as helping to avoid recession by burnishing the Fed’s inflation-fighting credentials. The more credibility the Fed has, the less it will have to lift rates.

In a nutshell, that is the debate on Fed policy speed.

There are other policy debates as well. Larry Summers thinks the economy and demand must be slowed to control inflation, and that will mean a significant rise in unemployment. The Fed contends that the economy can be slowed without creating a recession. Thus, the battle lines of disagreement are drawn.

The Fed has been criticized, and that’s continued even as it hikes rates; some urge a firmer framework for policy. Paul Volcker had a framework. He went on a three-year fight against inflation and won. His campaign ended in November 1982 when it began to look too risky to continue. Mike Tyson used to say everyone has plan until they get punched in the face. Generals say every war has a plan until the first battle, and so on.

What we know about the economy leads me to think that we should not even bother trying, since no plan makes sense. Ben Bernanke substituted an announced inflation objective for an intermediate policy target (instead of targeting money supply growth, for example). John Taylor proposed the Taylor rule, which now exists in various forms. Taylor offered it as a rule that tracked past monetary policy rather well. The problem now is that adopting a Taylor rule would skyrocket interest rates to certain recession-creating territory.     

Time-tested rules won’t work

Looking at the situation fairly, a number of factors suggests that traditional rules and approaches may not work because of the unusual economic conditions that prevail.

No. 1: The fed funds rate is very far below the inflation rate. Conventional wisdom has the funds rate above inflation to be effective. This gap suggests policy is way too loose.

No. 2: The Treasury yield curve is inverted — short-term rates are higher than long- term rates. That suggests the market thinks policy is tight enough or even too tight.

No. 3: Still, the 10-year note yield is barely above the top of the fed funds rate target — that seems way too low.

No. 4: On the other hand, inflation expectations out five to 10 years in the University of Michigan survey are only in the 3% to 3.5% realm. Despite how high inflation is, survey respondents do not expect it to endure.

These are not just inconsistent signals; they are contrary conditions. No econometric model is built with these conditions as the building blocks of any forecast. Any economist with an opinion on policy endorsing a framework is throwing out one or more of these factual relationships to draw his or her conclusion about what to do. So, what do you do when reality is in conflict with the normal conditions your model or your rules assume will prevail? You wing it.

This is what the Fed is doing. It is running experimental monetary policy, planning to raise rates by much less than traditional rules would say. The fact that the Fed’s models have not worked well for some time is reason to distrust them.

Many may hate or rue ad hoc policy, but in this case there may be no other choice. Unfortunately, that reality probably exposes the Fed to the greatest political vulnerability, since a Fed critic is going to have one of these tried-and-true gauges to throw up in the Fed’s face if something goes wrong.

And something almost certainly will go wrong. The Fed never has controlled inflation this high without having a recession do the dirty work. Why should now be different just because an election beckons? That  does not change the facts, only the risks.

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