Another Federal Reserve Post About Lessons Learned on Normalizing Monetary Policy: "Additional insight that only experience can bring"

"Let's start at the beginning" ... Federal Reserve Post About Lessons Learned on Normalizing Monetary Policy: "Additional insight that only experience can bring"

So, let's think about how the economy evolved and how the criteria for that guidance steered the path of policy. In early 2021, the Committee began noting whether the economy was making progress toward our employment and inflation goals, and thus getting closer to decisions on unwinding our highly accommodative policy. Based on our positive experience with unwinding after the Global Financial Crisis (GFC), we thought it would be appropriate to use the same sequence of steps: taper asset purchases until they ceased, then lift rates off the effective lower bound, then gradually and passively reduce our balance sheet by redeeming maturing securities. Most importantly, through various communications, we made it clear that tapering of asset purchases would have to be completed before rate liftoff to avoid the conflict that would occur by easing via continuing asset purchases versus tightening through rate hikes.

In the previous episode of tightening policy after extraordinary accommodation, this process was very gradual. Tapering of asset purchases took 11 months, and then the first rate hike did not occur until more than a year after purchases ended. Balance sheet reduction began more than a year and half after that. This gradualism worked well then, and it surely influenced the Committee's approach this time.

Implementing this approach required two pieces of guidance: first, criteria for beginning the tapering process, and, second, criteria to begin raising the policy rate from the effective lower bound. Through explicit language in FOMC statements, we told the public the necessary conditions that needed to be met before we would adjust these two policies.

For asset purchases, the Committee declared that tapering would wait "until substantial further progress has been made toward the Committee's maximum employment and price stability goals."4 Meanwhile, the FOMC said that it would keep rates near zero until our employment goal had been reached and until inflation had reached 2 percent and was "on track to moderately exceed 2 percent for some time."5

A fair question is: what did these words mean? And, in particular, what did the phrases "substantial further progress" for tapering and "for some time" for liftoff mean? In large part the interpretation hinged on how the Committee viewed the economy would recover from the pandemic. Looking across forecasts at the time by Committee participants and the private sector, no one expected substantial progress toward both our goals to happen very soon. The economy had begun the recover, but at the end of 2020 COVID was bad and getting worse and vaccines were just arriving, so we didn't know how soon schools would reopen and people would get back to work. In November and December 2020, the unemployment rate was 6.7 percent and inflation seemed to be in check: 12-month personal consumption expenditures inflation was declining, and core inflation, which excludes volatile energy and food prices, was more or less steady at 1.5 percent. The Summary of Economic Projections by FOMC participants in December 2020 had the unemployment rate moving down to 4.2 percent at the end of 2022 and inflation moving up to 2 percent only in 2023. Only one participant had liftoff occurring by the end of 2022.

Based on this SEP, the Committee did not expect the economy to recover quickly. And, looking at the Federal Reserve Bank of New York's Survey of Primary Dealers back in January of 2021, the median respondent thought tapering would start in the first quarter of 2022 and liftoff wouldn't be until the end of 2023 or later.

To move forward, policymakers had to evaluate "substantial further progress" and "for some time." The phrases, admittedly, are not concrete in their meaning. Inflation averaging doesn't define how much above 2 percent is moderate and how long some value of elevated inflation should be tolerated. In addition, for assessing progress on the health of the labor market, different policymakers will prefer different measures that may not provide the exact same signal. On top of this, the data used to measure progress in the labor market can revise substantially and reshape the evaluation of the strength of this market quite quickly. For example, a key input — payroll data — in the latter half of 2021 painted a picture of a slowing labor market. But revised data over several subsequent months revealed that the slowdown never happened. Instead, job gains were quite robust. In particular, initial reports of job creation between August and December were a cumulative 1.4 million, but by February of this year that number was revised up to nearly 2.9 million.

Overall, the economy evolved rapidly in 2021. I won't get into the month-by-month details, as I have in recent speeches, but by October and November, policymakers thought the economy had improved enough to meet the criteria to start tapering at the early November meeting. Then, later that month, data indicated inflation was accelerating, so the Committee hastened the pace of tapering at the December meeting, making a plan to wind down purchases by early March. Between December and March of this year inflation data came in very elevated, and at that point there was no question that inflation had been above 2 percent for "some time." Given continued improvement in the labor market and the high inflation readings, the Committee began raising interest rates in March, as soon as asset purchases were completed.

With these actions in the rearview mirror, we can now ask: knowing what we know now, should we have done anything differently? To be clear, by asking this question my intent is not to criticize the decisions of the Committee. Rather, it is to assess our policy strategies should we be confronted with another crisis in the future.

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"Let's start at the beginning" ... Federal Reserve Post About Lessons Learned on Normalizing Monetary Policy: "Additional insight that only experience can bring"

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