Jay Powell grapples with how the Fed got inflation so wrong and lands on the MarketWatch 50 list of the most influential people in markets.
The first was being unaware that the foundation of the U.S. banking system had been eroded away by complex mortgage securities carrying high credit ratings, but which turned out to be toxic during a broad housing downturn. The resulting meltdown in valuations caused the global financial crisis in 2008 that hobbled the U.S. economy for years.The first was being unaware that the foundation of the U.S.
For now, outside experts are debating the causes that led to the big policy mistake. Some Fed officials, including Powell, have started to chime in. Here are the four underlying causes of the initial policy error that emerged in interviews with experts. They include the Fed’s new policy framework, Powell’s distrust of forecasts, unintended consequences of some forward guidance the Fed gave markets in 2020, and the nature of the pandemic’s perfect economic storm.
“The framework document came after 20 years of it being very difficult to get inflation to 2%. And so, unfortunately, the framework assumed that type of environment was going to persist,” said former Boston Fed President Eric Rosengren, in an interview. “That might work out OK, but if inflation occurs with ‘long and variable lags,’ as Milton Friedman famously said, then a reactive policy will always be behind the curve, an exercise in futility,” Stanley said. “By the time the Fed realized that policy was too easy, the inflation genie will be out of the bottle. By the way, this is exactly the approach that got the Fed in so much trouble in the late 1960s and 1970s.
When confronted with high inflation, “they were determined not to overreact to what seemed like a special event,” he said. “The Fed should be looking ahead, not looking around,” Nelson wrote in a summer email to colleagues. “It’s the same as driving a car. For a smooth ride, you need to look ahead. If you just look at your immediate surroundings, you end up having to slam on the brakes or accelerating” so fast you have to slam on the brakes eventually.
As part of its forward guidance, Powell and the Fed wanted to lay out the criteria needed to slow down and end the bond purchases and also when it would contemplate the first rate hike. While the Fed never defined “substantial further progress,” financial market participants took it as a clear sign that the Fed wouldn’t even think about raising interest rates until 2022. This ended all talk of tapering its bond purchases for six months, and meanwhile inflation pressures gathered steam.
The perfect storm The kindest explanation for the Fed’s error was that the pandemic resulted in a perfect storm that no one could predict.
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