With Inflation on the Rise, Powell Sticks to His Guns

On Wednesday, the Federal Open Market Committee (FOMC) held another meeting to discuss monetary policy. While the labor market continues to improve as the Covid-19 pandemic recedes, employment levels remain well below pre-pandemic levels, especially in the leisure and hospitality sectors. As such, the FOMC announced that there were no major changes in Fed policy, and that the central bank will remain “committed to using its full range of tools to support the U.S. economy in this challenging time.”

This means the Fed will keep the federal funds rate between zero and a quarter-of-a-percent while continuing to increase its Treasury and mortgage-backed securities holdings by at least $80 and $40 billion respectively. Furthermore, the committee held fast on their average inflation targeting objectives, stating that they “will aim to achieve inflation moderately above 2 percent for some time so that inflation average 2 percent over time and longer-term inflation expectations remain well anchored at 2 percent.” However, there were a couple small policy tweaks made during Wednesday’s meeting, as the FOMC decided to raise the interest rate paid on required excess reserves and the overnight reverse repo rate by 5 basis points. These actions will help keep the federal funds rate within the Fed’s target range while also supporting the smooth functioning of broader money markets.

Though most of these policy decisions were largely expected of the Fed going into this meeting, concerns have lingered over the Fed’s commitment to their average inflation target of 2 percent. Last week, the Department of Labor announced that one of the common measures of inflation, the consumer price index (CPI), jumped 5 percent year-over-year. This not only exceeded the market’s expectations but was the highest pace of inflation growth since the summer of 2008, when the economy was experiencing a major recession.

During its meeting on June 16, 2021, the Fed released its quarterly Summary of Economic Projections (SEP), which includes forecasts of major economic indicators such as inflation, real GDP, and the unemployment rate. Consistent with the elevated CPI readings from May, Fed board members forecasted higher personal consumption expenditure (PCE) inflation, as projections have risen to 3.4% - a full percentage point increase from the previous SEP released in March. These jumps in inflation, coupled with rising vaccinations and elevated forecasts of real GDP growth, have also led to another major change–a projected interest rate hike by 2023.

According to March’s projection materials, FOMC participants were largely not expecting any rate hikes over the next few years, as median interest rate projections remained around 0.1 percent through 2023. However, with inflation surging in the last few months, the FOMC’s newest dot plot, which demonstrates the midpoint of the target range and level for the federal funds rate, showed a small shift in the expected path of interest rates from the committee’s participants. According to Wednesday’s projection materials, FOMC members now forecast the federal funds rate will hit a median level of 0.6% by 2023, signaling the first interest rate hike since the pandemic took hold of the economy in early 2020.

These expectations of higher interest rates paired with rising levels of inflation have caused concern that the Fed won’t be able to remain committed to its 2 percent average inflation targeting framework and will lose control of inflation as the pace of the recovery quickens.

During the press conference following the FOMC meeting, Fed Chair Jerome Powell reassured reporters not to worry. Powell was quick to point out that incoming data are consistent with the view that elevated prices are the result of recovery within the sectors of the economy that were most directly affected by the pandemic. Powell stressed that the jumps in inflation are transitory, as prolonged supply bottlenecks and the temporary effects of a reopening economy are the main components leading to higher inflation. Most importantly, Powell stressed that longer term inflation expectations have reversed from previous declines, and that these longer run expectations have now moved into a range that is consistent with the Fed’s average inflation targeting goal.

The Fed chair’s message remains clear: high inflation readings should start to abate in the future, but if the Fed starts to notice inflation expectations rising in a truly persistent way, the central bank will use their wide range of tools to keep levels consistent with their stated goals. Powell also stressed that the recent economic data and the projections released in June’s SEP should be ultimately viewed as good news for the large macroeconomy.

His general takeaway: the data shows that many FOMC participants are more comfortable that the macroeconomic goals will be met sooner than anticipated, meaning the economy has made faster progress toward a full recovery than initially expected.