What is the Fed Doing?

 A brief note on the Federal Reserve Bank monetary policy.

For context the Fed has two monetary policy goals which are mandated by Congress.  The traditional goal and the goal of all central banks is to facilitate a stable currency, i.e., control inflation.   This doesn't mean no inflation.   In fact, the goal of most central banks is not to have no inflation but to have a steady inflation rate close to 2%.

 The second goal which is specific to the US Fed is to encourage full employment.   Note that the other major central banks; ECB, Bank of England, Bank of Japan don't have this as a specific objective.   

The basic tools of central bank monetary policy are to manage short term interest rates.  In times of low inflation or a weak economy the Fed aims for negative real interest rates.  This means that the nominal rate is less than the inflation rate.   However, when inflation is low and had been low for decades before the pandemic the Fed was constrained by the "zero lower bound".   That is, if inflation rate is very low - say 1.5% and the ideal real interest rate should be -2% then the zero lower prevents the central bank from achieving this.  This has been the situation for the ECB from the Great Financial Crisis up to the pandemic.

So, when the zero lower bound limitation arises the central bank uses two other monetary policy tools - Quantitative Easing (QE) and Forward Guidance.    QE is when the central bank buys long duration bonds the idea is to add liquidity to the economy and to lower longer duration interest rates.  In the US example the interest rate on 10-year Treasury Bonds is the main focus of QE.

Forward Guidance is less important.  It is merely the "promise" of the central bank that it will keep interest rates for an extended period of time.

Historically when the economy approaches full employment and inflation approaches the 2% goal the Fed would increase interest rates.  The idea is to slow demand in the economy and avoid "over-heating" which could lead to persistent inflation over 2%.

Because of the pandemic the Fed changed its policy tools.    They predicted inflation would be "transitory" due to pandemic related supply change disruptions.  They also thought that even though unemployment levels were low there was still "slack" in the labor market.  The labor participation rates have not recovered to the pre-pandemic levels.   Measured by historical unemployment rates and current inflation rates the Fed should have started to use their tools to slow demand.   They didn't.  Instead, they left short-term interest rates essentially at zero and continued to use QE to lower long term rates and add liquidity to the economy and the financial markets.  They also announced that they would slow the QE bond purchases (Quantity tapering) and only after they ended QE would they begin to raise interest rates.

Inflation was close to 7%, unemployment rate was less than 4% and the Fed was implementing expansive monetary policies rather than slowing demand.  The current phrase being used is that the Fed is "behind the curve".  Since they are moving slowly to curb demand there is a possibility of inflation rising well above 2% and staying there.  Then the Fed will have to raise interest rates to such a level that they may cause a recession.