Fed charts faster course away from unprecedented stimulus

The Federal Reserve is pivoting hard from a patient approach to pulling back support for the U.S. economy. 

Fed officials on Wednesday charted a much faster return from the unprecedented stimulus they deployed at the onset of the coronavirus pandemic than they’d initially planned. The bank’s policymaking committee announced it would aim to end its monthly purchases of Treasury and mortgage bonds by March, and expects to hike interest rates roughly three times by the end of 2022.

The Fed has held off on reducing stimulus even as inflation rose for much of this year. Millions of workers remained on the sidelines for more than a year and officials were reluctant to cut support, expecting more Americans to return to work as the pandemic eased and fiscal stimulus faded.

But Fed officials have acknowledged they no longer have time to hold out for a mass return to the labor market with inflation reaching its highest level in more than 40 years.

“The reality is we don’t have a strong labor force participation recovery yet, and we may not have it for some time,” Fed Chair Jerome Powell said at a Wednesday press conference following the December meeting of the Federal Open Market Committee (FOMC), which sets monetary policy.

“At the same time, we have to make policy now and inflation is well above target. So this is something we need to take into account,” he continued.

By slashing interest rates to near-zero levels in March 2020, buying trillions of dollars in bonds, and deploying billions in emergency loans, the Fed helped power a surprisingly strong recovery from the worst economic shock in a century. The jobless rate dropped to 4.2 percent in November, growth is on track to exceed 5 percent, and layoffs have fallen to the lowest level in more than 50 years.

The Fed’s response — along with more than $5 trillion in fiscal stimulus and the breakthrough of mRNA coronavirus vaccines — was a key force behind a far faster recovery than many economists anticipated.

Even so, the pace of that rebound has overwhelmed supply chains with intense demand for goods and stoked inflation higher. At the same time, the labor force participation rate remains 1.5 percentage points below its pre-pandemic level.

Typically after a major economic shock, “there aren’t enough jobs and people can’t find jobs and we’re stimulating demand and trying to get demand to come up. That’s not the problem here. The problem is a supply-side problem,” Powell said Wednesday.

Consumer spending has risen above pre-pandemic levels, but remains disproportionately focused on goods instead of services and activities with more face-to-face exposure. As spending surged in the face of the virus, manufacturers, suppliers, shipping companies and retailers steadily raised their prices while constrained by port bottlenecks, raw material and component shortages, and staffing issues in critical industries.

As inflation rose, the Fed had faced growing pressure from Republican lawmakers and even some prominent Democrats, such as former Treasury Secretary Larry Summers, to halt stimulus before the economy began to overheat. But Powell and Fed officials had urged patience in the face of what they called “transitory” inflation, insisting supply chain snarls and lagging labor force participation driven by the pandemic would soon begin to ease. 

“[The Fed] could have been right if the supply side of the economy was able to respond faster and stronger,” said Adam Ozimek, chief economist at Upwork, who warned in June the bank could face pressure as stimulus-boosted demand ran up against supply constraints.

“It’s clear that the fiscal stimulus pushed demand faster than the economy could handle and kept it tilted towards the more-inflationary goods sector,” he continued.

Powell, like many economists, has acknowledged drastically underestimating how long pandemic-related supply issues would last and how high they would stoke inflation. 

Inflation as measured by the Commerce Department’s personal consumption expenditures index without food and energy prices — the Fed’s preferred gauge of price growth — rose 0.4 percent in October and 4.1 percent annually. 

The median estimate among FOMC officials for year-end inflation rose to 4.4 percent, according to projections released Wednesday, up from an estimate of 3.7 percent in September.

“It’s clear they’re paying attention,” said Christopher Russo, a research fellow at George Mason University’s Mercatus Center, a libertarian-leaning think tank.

“Inflation has quite obviously remained well above what forecasters at the Fed and in the private sector and elsewhere have been forecasting, and so they’re adapting policy.” 

Powell said Wednesday that while he had hoped for labor market participation to catch up as federal unemployment benefits expired and schools reopened, the U.S. now faces risks from stimulating an economy quickly bumping up against its maximum potential during the pandemic.

The Fed chief said that a September string of strong jobs reports, major increases in earnings and steep increases in consumer prices prompted concerns about inflation rising beyond the grip of the pandemic.

“The risk of higher inflation becoming entrenched has increased,” Powell said, adding it’s “not high at the moment.”

“Part of the reason behind our move today is to put ourselves in a position to be able to deal with that risk,” he continued.

After forcing Powell’s hand, the persistence of the pandemic could still throw another wrench into the Fed’s pivot.

Economists are still unsure how the emergence of the omicron variant could affect the pace of the recovery and inflation. While the delta variant slowed job growth, particularly in service sector industries, inflation rose sharply as cash-flush consumers pivoted back to goods purchases.

A steep coronavirus-driven decline in consumer activity could take some pressure off of inflation and allow the Fed to move ahead slower. More supply chain snarls could push the Fed in the opposite direction.

“I’m not concerned the Fed is going to cause a recession. I am concerned the Fed is going to slow things down,” Ozimek said. 

“And after decades of the Fed leaning on slowing things down too much. I’m worried about more of that. I think we need to be in a hurry and get back to full employment.”