The Great Recalibration of U.S. Monetary Policy

At the start of the pandemic in March 2020, the FOMC reduced the target range of its policy rate, the federal funds rate, to 0 to 1/4 percent, ... Skiptomaincontent Careers DiversityEquityandInclusion Facebook Instagram LinkedIn Twitter YouTube Togglenavigation Menu OurResearch Economists CenterforInflationResearch IndicatorsandData Publications ResearchTopics ResearchAnalysts Events Region RegionalAnalysis State Topic BeigeBook IndustrialHeartland CommunityDevelopment AboutUs PublicationsbyDate PublicationsbyTopic ToolsandResources Events PolicySummit CommunityAdvisoryCouncil Banking Overview ConsumerResources BankerResources DataResources NewsroomandEvents COVID19 Events Interviews PressReleases Reflections Publications Speeches ClevelandFedDigest MultimediaStorytelling InfographicsLibrary Subscribe AboutUs AtaGlance TheFederalReserve TheClevelandFed OurDirectors OurOfficers AdvisoryCouncils DiversityandInclusion TreasuryServices Careers SpeakersBureau LearningCenterandMoneyMuseum About VisitUs ScheduleaTour ProgramsandResources OutreachandPartnerships ContactUs COVID-19 Events FedTalk PastEvents VisitorEntryRequirements Interviews PressReleases Publications AnnualReports CommunityDevelopmentPublications DistrictDataBriefs EconomicCommentary MetroMix WorkingPapers DiscontinuedPublications Speeches ClevelandFedDigest AsktheExpert Collection MultimediaStorytelling InfographicsLibrary Subscribe Print TheGreatRecalibrationofU.S.MonetaryPolicy 05.13.22 LorettaJ.Mester InternationalResearchForumonMonetaryPolicy:MonetaryPolicyDuringandAfterthePandemic,EuropeanCentralBank,Frankfurt,Germany(viavideoconference),May13,202212p.m.ET MeettheAuthor LorettaJ. Mester PresidentandChiefExecutiveOfficer LorettaJ.MesterparticipatesintheformulationofU.S.monetarypolicy,andoversees1,000employeesinCleveland,Cincinnati,andPittsburghwhoconducteconomicresearch,supervisebankinginstitutions,andprovidepaymentservicestocommercialbanksandtheU.S.government.SheassumedherroleaspresidentandCEOinJune2014. Readbio… (PDF ) ItisapleasuretoparticipateinthispolicypanelattheInternationalResearchForumonMonetaryPolicysponsoredbytheEuroAreaBusinessCycleNetwork,theEuropeanCentralBank,andtheFederalReserveBoard.TheFederalOpenMarketCommittee(FOMC)metlastweek;soinmybriefpreparedremarks,IwillreviewtheFOMC’srecentdecisionsandputthemintocontext.Asareminder,theviewsIpresenttodaywillbemyownandnotnecessarilythoseoftheFederalReserveSystemorofmycolleaguesontheFederalOpenMarketCommittee. Inmakingitsmonetarypolicydecisions,theFOMCisalwaysguidedbyitsstrongcommitmenttoachievingitsgoalsofpricestabilityandmaximumemployment.AtthestartofthepandemicinMarch2020,theFOMCreducedthetargetrangeofitspolicyrate,thefederalfundsrate,to0to1/4percent,tosupporttheeconomyinthewakeoftheunprecedentedCOVIDshock.TheFOMCalsouseditsbalancesheetasapolicytool,buyinglargequantitiesofTreasurysecuritiesandagencymortgage-backedsecurities,toreducetheseverestrainsinfinancialmarketsseenearlyinthepandemicandtosupporttheeconomy.InMarchofthisyear,theFOMCraiseditspolicyrateby25basispoints.Lastweek,itraisedthefedfundsratebyanother50basispointsandindicatedthatitbelievesongoingrateincreaseswillbeappropriate.TheFOMCalsoannouncedthatitwillbeginreducingitsbalance-sheetassetsstartinginJune. TheseactionsarepartofwhatIhavecalledtheGreatRecalibrationofU.S.monetarypolicy:ashiftfromtheextraordinarilyaccommodativepolicyneededearlierinthepandemictoapolicystancethatismoreappropriateforaddressingthekeychallengefacingtheU.S.economy:unacceptablyhighinflation.1WhileliftoffofthefundsratefromzeroonlyoccurredinMarch,thisrecalibrationactuallybeganintheautumnoflastyear.LastSeptember,theFOMCindicatedthatitwouldsoonbetimetotaperassetpurchases,anditannouncedthebeginningoftaperinginNovember.InDecember,theFOMCspedupthetaperingandreleasedprojectionsindicatingthatparticipantsnowexpectedanearlierliftoffofthepolicyratethantheyhadpreviouslyanticipated.InJanuary,theFOMCindicatedthatitwouldsoonbetimetoraiseitspolicyrate,andthenfollowedthroughwiththefirstincreaseinMarch.AssetpurchasesalsoendedinearlyMarch. Thisrecalibrationofpolicyhasreflectedtheevolutionofeconomicconditions,theeconomicoutlook,andtherisksaroundtheoutlook. Despitethechallengesposedbythepandemic,U.S.economicgrowthwasverystronglastyear,withrealGDPgrowingata5-1/2percentrate,thehighestannualpacesince1984andwellabovethetrendgrowthrate,whichIestimatetobeabout2percent.ThedeclineinrealGDPinthefirstquarterwasdrivenmainlybydeclinesinnetexports,governmentspending,andastillhighbutlowerlevelofinventoryinvestmentcomparedtothefourthquarteroflastyear.Growthinconsumerspendingandbusinessfixedinvestmentremainedsolidlastquarterandtherecontinuestobepositiveunderlyingmomentumindemand.Householdandbusinessbalancesheetsarehealthy,reflectinghighsavingsaccumulatedduringthepandemic. Strongdemandhasoccurredinthefaceofveryconstrainedsupplyinbothproductandlabormarkets.Inproductmarkets,differencesinvirusconditionsandviruscontainmentpolicieshaveresultedinacascadeofdisruptionstotheglobalsupplychain.China’szero-COVIDpolicyhasfurtherdisruptedsupplychainsandRussia’sdastardlyinvasionofUkrainehasfurtherconstrainedsuppliesinenergy,metals,andagriculturalcommoditymarkets. Labormarketsremainverytight.TheU.S.economyadded6.7millionjobslastyear.Despitewidespreadreportsfromfirmsaboutthedifficultyoffindingworkers,monthlypayrollgainshaveaveragedabove500thousandoverthefirstfourmonthsofthisyear.Theunemploymentratehasfallento3.6percent,nearlyaslowasitslowestreadingduringthepre-pandemicexpansion.Laborforceparticipationremainsbelowitspre-pandemiclevel,butithasimprovedsignificantlyovertime.Still,laborsupplyhasbeenunabletokeepupwiththerobustdemandforlabor.Jobopeningsareatveryhighlevelsbyhistoricalstandards:therearealmost2openingspereveryunemployedworker;in2019,thisratioaveraged1.2openingsperunemployedworker. Withdemandoutofbalancewithsupplyinbothproductandlabormarkets,pricesandwageshavemovedup.Pricepressureshavebroadenedacrossgoodsandservices,andinflationreadingsintheU.S.arenowattheirhighestlevelsin40years.Measuredyear-over-year,inMarch,totalPCEinflationwasover6-1/2percent,corePCEinflationwasnearly5-1/4percent,andtheClevelandFed’smedianPCEinflationwasalmost4-1/4percent.Wagepressuresarealsobuilding.TheemploymentcostindexforprivateindustryworkersacceleratedoverthethreemonthsendinginMarch,risingata5.8percentannualpace.Higherwagesthatreflecthigherproductivitygrowthareapositivefortheeconomy,andahigherlevelofwagesrepresentsashiftofincomesharefromcapitaltolabor.Butthecurrentpaceofwageincreasesisinconsistentwithmaintainingpricestability. TheFediscommittedtousingitstoolstogetinflationundercontrolbybringingexcessdemandintobetterbalancewithconstrainedsupply.Itwilllikelytakesometimeforinflationtoreachourlonger-rungoalof2percentbecauseseveralofthefactorsthathavecontributedtotheveryhighinflationreadingsaresupply-sidefactors,whichmonetarypolicycannotaffect,andbecauseinflationtendstobepersistent.Butaswerecalibrateourpolicy,Iwillbelookingforcompellingevidencethatinflationisonadownwardtrajectorytowardour2percentgoal.Wewillbeabletogaugeimprovementbylookingatthemonthlychangesininflationreadingstoseeifinflationisbeginningtomovedown.ThemonthlyincreaseinthecorePCEpriceindexinMarchwaslittlechangedfromitsFebruaryreading,andthemonthlyreadingoftheClevelandFed’smedianPCEinflationmoveddowninMarch.Thesearepositivesigns,butinApril,monthlyCPIinflationincreased,andriskstoinflationremainstronglyontheupside,especiallyinthemidstofthecontinuingwarinUkraineandthepotentialthatthezero-COVIDpolicyinChinawillfurtherdisruptsupplychains.IwillneedtoseeseveralmonthsofsustaineddownwardmonthlyreadingsofinflationbeforeIconcludethatinflationhaspeaked. Arisk-managementperspectivearguesforsuchcautionbecauseinflationrisksaretotheupsideandbecausethelongerinflationrunsaboveourgoal,thehighertheriskthatlong-terminflationexpectationswillbecomeunanchored,therebymakingthereturntopricestabilitymuchmorecostly.Wealreadyseethatmedium-andlonger-terminflationexpectationshavemovedup.TheBoardstaff’smeasureofcommoninflationexpectations,whichsummarizesanumberofmeasures,hasbeenrisingandisattheupperendoftherangeofvaluesseensince2005.2Eventhoughsomeoftherisehasbeendrivenbyincreasesinnear-termexpectations,Idonotthinkitisprudenttoignoretherisegiventheseriousharmthatwouldbecausedwerelong-termexpectationstomoveabovelevelsconsistentwithourlonger-runinflationgoalof2percent.3 Inmyview,theFOMCwillneedtoberesoluteandintentionalinremovingpolicyaccommodationatthepaceneededtogetinflationundercontrol.Highinflationimposesarealburdenonhouseholdsandbusinesses,especiallythosethatdonothavethewherewithaltopaymoreforessentialgoodsandservices.Ifwefailtodowhatisnecessarytogetinflationdown,wewillbejeopardizingsustaininghealthylabormarketsoverthemediumandlongerrun,againhurtinglower-incomehouseholds.SoIdonotseethecurrentsituationasoneinvolvingatrade-offbetweenourtwogoals. Thecurrenttargetrangeofthefederalfundsrateis75to100basispoints.Thisiswellbelowtherangeofestimatesofthelonger-runneutralnominalpolicyrate,whichneitherstimulatesnorrestrainseconomicactivity.Forexample,intheMarchSummaryofEconomicProjectionsofFOMCparticipants,therangeofestimatesofthelonger-runfedfundsratewas2to3percent.Therealfedfundsrateisstillnegative.Sogiveneconomicconditions,ongoingincreasesinthefedfundsratearecalledfor,andunlesstherearesomebigsurprises,Iexpectittobeappropriatetoraisethepolicyrateanother50basispointsateachofournexttwomeetings. Atthatpoint,thenominalfundsratewillbenearingthelowerendofestimatesoftheneutralrateandbalance-sheetreductionswillbeunderway.TheFOMCwillthenbewellpositionedtoconsidertheappropriatepaceatwhichtocontinueremovingaccommodationoverthebalanceoftheyearandhowfaraboveneutralrateswillneedtogo.Itwillbechallengingtoremoveaccommodationatthepaceneededtogetinflationundercontrolwhilesustaininghealthylabormarketconditions.Therearelikelytobesomebumpsalongtheroad;growthcouldslowabitmorethanexpectedforacoupleofquartersandtheunemploymentratecouldmoveuptemporarily.Nonetheless,theFOMCwillbeaimingtocalibrateourpolicytobringdemandbetterinlinewithsupply,therebyputtinginflationonadownwardtrajectorytowardour2percentgoal.Thiscalibrationwillentailassessingthevariousforcesthatwillbeaffectingthedemandandsupplysidesoftheeconomy.TheongoingwarinUkraineandtheCOVIDlockdownsinChinaposeupsideriskstoinflationbutdownsideriskstogrowth.Broaderfinancialconditionshavealreadytightenedconsiderably,asmarketshaveanticipatedfurtherrateincreasesinlightoftheFed’sforwardguidance.Forexample,the30-yearmortgageratewasunder3percentlastSeptemberandisnowabout5-1/4percent.AndtheFed’sbalance-sheetreductionwillsoonbeunderway.Thesetighterfinancialconditionswillhelpmoderateexcessdemand.Withsomeluck,supplychaindisruptionswillbegintoabateandlabormarketparticipationwillcontinuetorise,helpingtoeasesupplyconstraintsandallowingsupplyinproductandlabormarketstocomeintobetterbalancewithdemand.Butwecannotrelyonluck.Withbothsupplyanddemandadjustingovertime,Iwillbemonitoringeconomicandfinancialdevelopmentscloselytogaugethebalancebetweendemandandsupplyandtodetermineappropriatemonetarypolicy.IfbytheSeptemberFOMCmeeting,themonthlyreadingsoninflationprovidecompellingevidencethatinflationismovingdown,thenthepaceofrateincreasescouldslow,butifinflationhasfailedtomoderate,thenafasterpaceofrateincreasesmaybenecessary. AsImentioned,inadditiontoraisingourpolicyrate,weareinitiatingthebalance-sheetreductioninJune.ThiswillbedoneprimarilybyadjustingthereinvestmentamountsoftheprincipalpaymentstheFedreceivesonitsassets.StartinginJune,theFedwillallowupto$30billionpermonthofTreasurysecuritiesandupto$17.5billionofagencysecuritiestorunoffthebalancesheet.Afterthreemonths,thesecapswillriseto$60billionpermonthforTreasuriesand$35billionpermonthforagencysecurities.TotheextentthatmaturingTreasurycouponsecuritiesarelessthanthemonthlycap,Treasurybillswillmakeuptherestoftherunoffuptothecap. TheplanthattheFOMCannouncedlastweekdidnotruleoutassetsales,andIwouldfavortheFOMCconsideringassetsalesafterbalance-sheetreductioniswellunderwaytospeedupthereturnoftheportfolio’scompositiontobeingprimarilyTreasurysecurities.ThiswouldbeconsistentwiththeFOMC’sstateddesiretominimizetheeffectoftheFed’sbalance-sheetholdingsontheallocationofcreditacrosseconomicsectors. TheplanalsodidnotindicatewhatsizethebalancesheetwillbewhentheFOMCendsthereductions,butitdidgivesomeguidance.Weareimplementingmonetarypolicyviaanamplereservesoperatingregimeinwhichreservelevelsareampleenoughthatcontroloverthefederalfundsrateandothershort-terminterestratesisexecutedprimarilythroughsettingtheFed’sadministeredratesandactivemanagementofthesupplyofreservesisnotneeded.TheFOMCintendstoslowandthenstopthereductioninbalance-sheetassetswhenreservebalancesaresomewhatabovethelevelitjudgesisconsistentwithamplereserves.Oncerunoffhasstopped,reservebalanceswilllikelycontinuetofallforatime,reflectinggrowthinotherFedliabilities,untiltheFOMCjudgesthattheyhavereachedtheamplelevel.Atthatpoint,theFOMCwillthenmanageitssecurityholdingstomaintainamplereservesovertime.Theamplelevelofreservesisuncertain.Itwilldependonthebankingsector’sdemandforreserves,aswellasthedistributionofthatdemandacrossinstitutions,whichwillevolveovertime.Soastheprocesstoreducethesizeofthebalancesheetprogresses,wewillbemonitoringdevelopmentsinmoneymarketstodeterminetheappropriatelevelofreservesatwhichtoendbalance-sheetrunoff,consistentwithmaintainingamplereservebalancesovertime. ThisconcludesmybriefremarksabouttheGreatRecalibrationofU.S.monetarypolicy.Ilookforwardtoparticipatinginthediscussion. Footnotes JeffCox,“Fed’sMesterCastsDoubtontheNeedfor‘Shock’InterestRateHikesAhead,”CNBC,April22,2022(https://www.cnbc.com/2022/04/22/feds-mester-casts-doubt-on-the-need-for-shock-interest-rate-hikes-ahead.html). Return SeeHieJooAhnandChadFulton,“ResearchDataSeries:IndexofCommonInflationExpectations,”FEDSNotes,BoardofGovernorsoftheFederalReserveSystem,March5,2021(https://doi.org/10.17016/2380-7172.2873). Return TheClevelandFed’smeasureofyear-aheadindirectconsumerinflationexpectationsfortheweekendedMay9was6.7percent(https://cebra.org/programs/idd/indirect-consumer-inflation-expectations/). 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