The Federal Reserve has made two major policy blunders in the last 25 years.
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.
More recently, a misreading of the strength of the labor market and the persistence of price shocks sparked by the pandemic led to the highest inflation rate in 40 years and the final chapter of this saga is still to be written. The policy error paved the way for making 2022 the worst year in financial markets arguably since the 1930s. Both stocks and bonds have plummeted and Federal Reserve Chairman Jerome “Jay” Powell is at the center of the financial turmoil, landing him on the MarketWatch 50 list of the most influential people in markets.
Critics have pounced on the Fed. Powell’s insistence that rising inflation was “transitory” and would quickly dissipate once the economy reopened more fully has been called “probably the worst inflation call in Fed history” by Mohamed El-Erian, chief economic adviser for Allianz. The economist Stephen Roach has compared Powell to former Fed chair Arthur Burns, whose indecisiveness under intense political pressure led to the crushing inflation of the 1970s. As recently as March 2022, when the Labor Department was reporting a 7.9% annual rise in consumer prices, Powell and the Fed were just ending injecting liquidity into financial markets.
How Powell, who is not a trained economist, is ultimately remembered will depend on whether he’s able to tame inflation without driving the U.S. into a deep recession. It could still all end relatively well, but the debate about what signs the U.S. central bank ignored and why will be studied and debated for years to come.
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.
A new policy framework unveiled in August 2020
In August 2020, as the nation was emerging from COVID-19 lockdowns, Jay Powell’s Federal Reserve announced a monumental shift. For more than a year prior to the pandemic, the Fed had been working on a new policy framework and the pandemic wasn’t about to stop the U.S. central bank from implementing what it had been putting together.
“The economy is always evolving,” Powell said. The Fed interest rate committee’s “strategy for achieving its goals must adapt to meet the new challenges that arise.”
Powell was not referring to the extraordinary economic events associated with the early days of the pandemic. Instead, the policy shift had been designed for a world of low inflation, a reality that had dragged on for some two decades.
“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.
With the new playbook, the Fed essentially decided it would not raise interest rates at the first sign of a strong labor market, which had become a cardinal rule after the high inflation of the 1980s. Instead, the Fed would be more patient before using the blunt tool of raising interest rates to increase borrowing costs for business and consumers to tamp down inflation
This upended the Fed’s longstanding reliance on Phillip Curve models that say that tight labor markets and wage pressures are a main driver of inflation.
The change was greeted with skepticism by some experts, like Stephen Stanley, chief economist at Amherst Pierpont Stanley, a U.S. fixed-income broker. In an email to clients after the new framework was announced, Stanley said that, in effect, Powell had concluded that inflation was simply a mystery to the Fed, and since it has no ability to accurately predict inflation, it must simply react to it after the results are in.
“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.”
Today, both Rosengren and Stanley believe the new framework contributed to the current inflation outbreak.
“I think the framework actually did cause the committee to delay actions that it might have taken more aggressively under the previous framework,” Rosengren said.
A distrust of forecasts
Lou Crandall, chief economist at Wrightson ICAP, a research firm that analyzes Federal Reserve operations, said that Powell and his Fed collegauges, like many economists, didn’t keep up with the rapidly changing economic outlook.
When confronted with high inflation, “they were determined not to overreact to what seemed like a special event,” he said.
Crandall said Powell, a lawyer by training who worked for years as a partner at the Carlyle Group, a private equity firm, was very skeptical of economic models and forecasts.
“A career in private equity will make you a little bit skeptical of forecasts,” Crandall said.
““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.” ”
— Eric Rosengren, Former Boston Fed President
This led the Powell Fed to shift to “an outcome-based reaction function” instead of relying on forecasts. In other words, the Fed wanted to see “the whites of the eyes” of inflation rather than anticipating it over the horizon.
Bill Nelson, a former top Fed staffer who is now chief economist at the Bank Policy Institute, a lobbying firm for the biggest U.S. banks, is not a fan of using current levels to make policy.
“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.
Forward guidance turns into straightjacket for the Fed
The mistake that nags at Fed officials is slightly different. It relates to two pieces of “forward guidance” given to financial markets in 2020.
In the immediate aftermath of the financial crisis in 2008, bond market participants started to anticipate that the Fed would soon raise interest rates. The Fed didn’t want longer-term bond yields to rise so it gave the market guidance that it was not changing course for a long time. This kept interest rates low. In the end, the Fed didn’t raise its benchmark interest rate until 2016.
Since almost the onset of the pandemic, the Fed was buying $120 billion of Treasuries and mortgage-backed securities each month to support the markets and the economy, as well as keeping interest rates low.
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.
The market understood from Powell and other Fed officials that ending bond purchases was a precondition to any rate hike. For the market, as long as the Fed was buying assets, it was not going to raise rates. In the last cycle, the Fed waited two years between ending purchases and hiking rates.
The rate-hike guidance came first in September 2020. The Fed said it wouldn’t raise its benchmark rate from close to zero “until labor market conditions have reached levels consistent with the (Fed interest rate committee’s) assessment of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time.”
In December 2020, the Fed followed up and gave forward guidance that it would keep buying bonds at the $120 billion monthly pace until “until substantial further progress has been made toward the Committee’s maximum employment and price stability goals.”
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 economy evolved rapidly in 2021,” Fed Gov. Christopher Waller noted in a speech last year.
Waller said it was an open question whether the guidance the Fed had issued “was too restrictive,” and might not have allowed enough flexibility for Powell and the other 11 voting members of the Federal Reserve’s Open Market Committee.
Asked about that forward guidance at a recent press conference, Powell said the Fed thought it needed to make a strong statement that it would get inflation back to 2%.
“I don’t think that that has materially changed the situation. But I have to admit, I don’t think I would do that again,” Powell said. He added that perhaps the lesson is to leave a little more flexibility in the forward guidance.
In the end, Powell said he was not sure it was a big deal.
“Did it matter in the end? You know, we—if you look at—I really don’t think it did. I’m not sure it would’ve mattered if we’d been raising rates three months earlier.”
Nevertheless, the Fed had to pivot hard and stopped all bond purchases only days before it raised its benchmark interest rate in March this year. In addition to Powell, other Fed officials, such as Cleveland Fed President Loretta Mester, have said that forward guidance would have to be improved during the next economic cycle.
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.
“The main issue was not seeing all the inflationary forces come together. In fairness, this was a perfect storm. Every possible thing that could lead to inflation happened,” said Mark Gertler, a professor of economics at New York University, who has co-authored papers with former Fed Chairman and Nobel winner Ben Bernanke.
The rapid economic recovery from the COVID-19 lockdowns led to a burst in demand, fueled by government stimulus payments to consumers and businesses, but also complicated by supply-chain disruptions related to the pandemic. The war in Ukraine was another major factor which pushed up oil prices and “you can’t blame the Fed for not foreseeing that,” Gertler said. Meanwhile, the slow return to work, retirements, and resignations from unpleasant work during the pandemic meant labor-market shortages pushed up wages.
With the benefit of hindsight these forces make sense, but economists didn’t anticipate them all ahead of time, Gertler said.
The long history of low inflation in the decade before the pandemic further muddied the waters. The Fed and other central banks had been trying and failing to push inflation to 2%. There were serious questions about whether central banks could even create inflation because there had hardly been any inflation for some 25 years. The expansionary fiscal and monetary policies coming out of the 2008 financial crisis had not generated a rise in consumer prices above the 2% target. “They just didn’t see this coming,” Gertler said.
Brian Bethune, an economics professor at Boston College, said that the National Bureau of Economic Research made a mistake when it formally called the two-month downturn at the start of the pandemic in March-April 2020 a recession. He said the economy quickly recovered and the recession label led the Fed and Congress to pour on stimulus that wasn’t needed.
Instead, Congress and the Fed were worried about the possibility of a new Depression and it led to Congress passing several massive fiscal relief packages and to the central bank holding interest rates at zero for too long.
For the Fed, however, financial storms come with the territory. The central bank did react strongly to its 2008 missteps. The Fed put in place capital requirements for the biggest banks and conducts annual stress tests to make sure that these banks have adequate capital to weather a severe recession.
But with their current battle with rising prices raging, Powell and other Fed officials don’t seem to think now is a good time to review their 2020 policy framework and their recent error on inflation.
“We can’t blame the framework. It was a sudden, unexpected burst of inflation. And then it was the reaction to it, and it was what it was,” Powell told reporters in March. The discussion, it seems, might have to wait until 2025, when the Fed said it would review the policy.