Has the Fed Been Tardy?

The April CPI report came out this morning. Inflation continues to recede into the past.

Long-term, my preferred inflation measure is core CPI less shelter, but since energy and food have been important contributors to price changes related to Covid and the Ukrainian war, CPI less shelter also is currently meaningful. This is both because, recently, the sharp trend changes in rent inflation tend to lag market rents on new leases, and more permanently because the change in the monthly rental value of the suburban LA home owned by the boomer couple with no mortgage has little bearing on the challenge of maintaining a stock of cash that will lead to stable nominal economic growth trends. So, I prefer CPI without the shelter component.

Figure 1 displays monthly and 3-month inflation rates for these measures:

Figure 1

There was a brief deflationary period upon Covid’s initial shock, then 2 years of high inflation. And now there have been 10 months of basically normal 2%-ish inflation again (when you back out shelter). The switch from high inflation back to normal inflation back in July 2022 was so abrupt, clear, and persistent, for the life of me, I can’t understand why there is still such consternation about the Fed’s ability to control it.

I mean, I guess CPI with shelter included is still high. But, surely, its lagging tendency is well understood by now.

Are we really going to go through a predictable 2 month process of acting like the Fed has finally gotten a grip on inflation because the May and June 2022 inflation drops off the back end of the 12 month measure? I guess it’s not the end of the world, and I generally feel like the Fed has everything in a decent range (partially because the strained housing market provides so much potential for growth that the target is very large), but it just seems weird that this is where we are months after Powell went to the trouble of talking about the biases of CPI shelter inflation.

On the topic of reacting to 12 month old price changes, in this post I want to review the question, “Has the Fed been tardy?”

Figure 2 compares CPI less shelter (here shown as levels rather than rates of change) and the Fed Funds target rate.

Figure 2

Again, here, we can see that after the brief Covid deflation, prices started a pretty linear climb through June 2022, and then flattened. The cumulative extra inflation was about 13%.

By the time the Fed raised the target policy rate in March 2022, cumulative inflation was already 11%. So, it seems rather obvious that the Fed was tardy in tightening policy because they didn’t even react until the inflation was nearly over.

But, then, this raises the question, if inflation came to an abrupt stop 4 months after the Fed reacted with any rate increases at all, did they ever need to raise rates to begin with? As of June 14, 2022, the Fed Funds rate was still only at 0.75%, and there hasn’t been a lick of excess inflation since then.

Courtesy of Scott Sumner and the market monetarist school, I think interest rate targeting is a confused way to thinking about monetary policy. But, it’s the language the Fed uses. And, so we have to consider all the complications required by using target interest rates. Were there expectations of rising rates? How much of a lag is there between the rate increase and its effect on prices?

Figure 3 compares the Eurodollar yield curve at 4 points in time. (The Eurodollar rate is similar to the Fed Funds target rate, but generally has a small spread so that it is slightly higher than the target rate.)

Figure 3

The red line is the yield curve just before that June rate increase. At that point, the market expected the target rate to top out around 3% (the rate in Figure 3 is 100 minus the price of the contract, on the y-axis). The Fed hit 3% at the September 2022 meeting, 3 months after excess inflation abruptly stopped.

Of course, the Fed has continued to raise the target to 5%. You can see that reflected in the blue line in Figure 3. But, notice that while the short-term rate has moved up a lot, the long term yield curve has remained practically unchanged.

Let’s say this was transitory inflation all along. Then, does the target rate really matter that much? Most debt is long term debt. I think the average bond duration is something like 7 years. Most at-risk investments have cash flows longer than that. If inflation will be 10% for 3 months and then everybody knows it will return to 2% after that, does that really matter at all to the investment marketplace? And, if the Fed sets the target rate at 10% or 0% for those two months, again, does it really matter?

So, I think we are left with some questions.

Did it matter if the Fed raised rates to stop inflation? If you believe in long and variable lags, it is plausible that the abrupt stop in inflation happened before any Fed policy decisions could have had much of an effect.

Maybe by then, there were expectations of a new 3% target rate, and so, maybe, 3% was what it took to stop it. Maybe.

How about subsequent hikes from either 0.75% where it was in June 2022, or 3% where expectations were in June 2022, to the current rate of 5%. Both the yield curve and the monthly behavior of inflation suggest that those hikes didn’t matter.

So, maybe, the Fed was tardy on the way up and on the way down. What do real rates and inflation expectations tell us? In Figure 4, I compare the 30 year mortgage rate, the nominal 10 year Treasury rate, and the portion of the rate that is associated with inflation vs. the real portion of the rate.

Figure 4

The entire rise in inflation expectations was already baked in by the time the Fed raised rates at all. At that point, the 10 year Treasury was still at 2% which is also about where the yield curve suggested that the Fed would stop raising the target rate. Between March 2022 and June 2022, the long term rate increased up to the 3%ish level where it remains today, but that was all from rising real rates. By the time excess inflation was finished, expectations of future inflation had already mostly reversed to normal. (The inflation premium in treasury rates under a 2% Fed target is slightly higher than 2% for technical reasons.)

One way that the interest rate focused monetary policy framework would explain this is that future rates are the reflection of future monetary policy targets, and so the rise in real rates after March 2022 reflected Fed credibility about future tightening, which they established by raising rates to combat inflation. So, the leveling out of inflation was a reflection of expectations and the subsequent rise of real rates reflects those expectations. The rise of the long end of the yield curve reflects an expectation that the Fed will keep rates higher in the future.

Home prices followed a similar pattern as CPI inflation, and so the credible expectations of tighter policy that increased forward real rates also raised mortgage rates, and this finally slowed down the housing market.

The Fed was tardy, but when they finally reacted, they established credibility, which raised mortgage rates and slowed down the housing market.

I indented those paragraphs to make it clear that I do not subscribe to that. I think there is a better explanation.

Mortgage rates were similar in June 2022, after a 40% rise in average home values, as they had been in late 2018. The shift to inflationary demand in housing had nothing to do with rates. And even if it would have been better to slow down housing, and even if higher rates could have done that, there is no plausible mechanism through which the Fed could have raised mortgage rates by manipulating their target rate.

The same thing happened from 2004 to 2007, when Greenspan and Bernanke kept expressing disappointment that mortgage rates never really increased at all over the entire period, in spite of their continued policy rate hikes. It is hard to raise long term rates by over-tightening monetary policy. Back then, it got so bad that by September 2008, the Fed couldn’t even move the target rate up to 2%, let alone long term rates.

The plain fact of the matter is that for a variety of real (not monetary) reasons, there was a spike in housing demand in 2020 and 2021 above the current capacity to meet it. There is nothing the Fed could do about it. Thank God they didn’t try.

And, in fact, the reason real rates finally rose in 2022 was because the Fed was “tardy”. The Fed credibly committed not to plunge us into a recession in a pointless attempt to stop transitory inflation or to destroy naturally occurring demand for housing. Real rates rose because being “tardy” was appropriate, and so expectations of future real economic growth have improved.

J-Pow FTW.

Eventually, they became tardy in stopping and reversing the rate hikes, but those late, temporary rate hikes don’t matter much.

Has the Fed been tardy?