Fed Listens Meets an Inflation Surge

Abstract

After the final Federal Open Market Committee meeting of 2022, Jay Powell paused to consider the past and prospective paths for the US Federal Reserve (the Fed). Entering 2023, Powell had three not-unrelated issues on his mind. First, in 2019 the Fed launched its first-ever comprehensive public review of the monetary policy framework it employs to achieve maximum employment and price stability. During this review, Powell and the Fed considered especially the neutral fed funds rate and what they had learned from low-income groups in the Fed Listens tour. Second, the COVID-19 pandemic had prompted the Fed to resume its extraordinary support for the US (and global) economy, a policy that had been in place since the 2008/09 Global Financial Crisis. Third, the 2022 inflation rate was at its highest level in a generation. Was this surge solely due to the Russia-Ukraine war–related adverse aggregate supply (AS) shock, or was Fed policy too loose? So, Powell had to think about how, if at all, the Fed Listens conversations should change US monetary policy in the face of surging inflation. How should extraordinary monetary policy stimulus end? More specifically, if the US economy was back on solid footing, how should the Fed guide the public through the eventual unwinding of its $8 trillion balance sheet? Or should it just live with a huge balance sheet? Relatedly, should the Fed be worried that it now held $5 trillion in Treasury holdings? Layer on all that the bane of central bankers' existence: a substantial sustained negative AS shock. Could the US economy—and, indeed, the global economy—weather a sustained Fed tightening phase?This case was written as an updated version of “Powell's Perilous Situation” (UVA-GEM-0156) and may be used in its place. It is taught at Darden in the first-year program elective, “Global Financial Markets.” It would also be suitable for any macro or international macroeconomics course.

Excerpt

Fed Listens Meets an Inflation Surge

If inflation fails to moderate, central banks will shift into a more aggressive monetary tightening stance, causing a sharply negative reaction in financial markets and most likely a significant economic recession.

—David Folkerts-Landau, chief economist at Deutsche Bank

After the final Federal Open Market Committee (FOMC) meeting of 2022, Jay Powell paused to consider the past and prospective paths for the US Federal Reserve (the Fed). So much had happened in his five years as chair of the Board of Governors of the Fed. His time as chair had started off roughly, to say the least, as the Dow Jones fell a devilish 666 points the day before he took over and twice by over 1,000 points in his first week. Things got better after the markets' less-than-warm welcome, but from the outset Powell had a difficult path to navigate. And now, entering 2023, inflation was at its highest level in 40 years, far above the Fed's 2% target (Figure 1).

Figure 1. Inflation and long-term inflation expectations.

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Keywords: Fed, Federal Reserve, Powell, Yellen, Bernanke, Greenspan, Volcker, financial crisis, quantitative easing, QE, quantitative tightening, COVID-19, coronavirus, pandemic, Russia, Ukraine, inflation, Fed Listens, stimulus, fed funds rate