Federal Reserve Chairman Jerome Powell recently stepped back from the cut and thrust of immediate policy matters to offer insight into Fed priorities—a review of what events and guidelines will prompt future decisions. Some of what Powell said provided comfort. Other things were not so reassuring. And still others raised fundamental questions about current financial structures.
Powell took up one immediate matter—the prospect of a pause in the pace of interest rate increases. In this context, he alluded to recent bank failures. He denied that policymakers might hold rates steady to relieve pressures on banks. He described counter-inflationary efforts and this kind of financial stabilization as “separate objectives.”
At the same time, he noted that fears in the banking community might convince some managers to reduce risk levels and otherwise slow the flow of credit into the economy—actions that would have a counter-inflationary effect, perhaps significant enough to obviate the need to raise rates.
The chairman has in the past offered other reasons for a pause: policymakers might need space to assess the lagged effect of past rapid interest rate increases. After denying inflation for most of 2021, last year’s rapid catch-up in the need to counter inflationary pressure leaves considerable uncertainty about the ultimate effects of these hikes on credit flows, the economy, and hence inflation.
Because interest rate moves always have variable and lagged effects, policymakers might need a pause to weigh those effects. Such a pause—whatever the reason—could as easily lead to renewed hikes as to a change of direction. All would depend on these now unknowable effects. Contrary to much media speculation, a pause would no more signal an end to rate hikes than anything else and certainly not a quick reversal in the Fed’s counter-inflationary policy.
The most encouraging aspect of Powell’s remarks was a reaffirmation of the Fed’s 2 percent inflation target. Some in the financial community have speculated that policymakers might settle for, say, 4 percent inflation, allowing them to ease away from counter-inflationary moves sooner than otherwise.
Dismissing this prospect, Powell made clear that such a compromise on inflation targeting would bring considerable economic harm. Because slack efforts to stem the inflationary tide would itself redouble inflationary pressure, such a changed target would ultimately mean “greater harm for families and businesses.”
Welcome as this news on inflation targets is, there is much ominous that came out in the chairman’s comments. Research done by the New York Fed on the so-called neutral interest rate—that which neither encourages nor discourages borrowing and lending—suggested that it is close to the low-interest rate levels that have prevailed for most of the time since the 2008–2009 financial crisis. This may be welcome news for Wall Street, which always loves low interest rates, but it paints an ugly picture of economic prospects.
Because underlying interest rates should ultimately reflect the returns in the broad economy—the reason businesses and people borrow and lend—low “neutral” interest rates suggest low underlying economic returns, an economy with little growth potential. This may be true, but it is an ugly prospect and one that should prompt the Fed and others in Washington not just to observe, as the New York Fed has done, but also to advance policies to improve that economic potential.
Another deeper policy matter emerged from Powell’s remarks. He stressed the need to stabilize the financial system now that some banks have run into trouble. Of course, in the immediate, urgent instance, there is little else the Fed and the Treasury could do. But these actions raise the question of whether the Fed’s willingness to step in each time a bank faces trouble implicitly encourages bankers to take more risk than they otherwise might.
If the Fed has committed to ensuring stability in this way, then it has an obligation to do a better job of controlling risk in the banking system. The Fed and Washington need to find more reliable arrangements, something as effective as banking was until the 1980s, if not that approach specifically.
For all the resulting questions and concerns, Powell’s comments should have clarified two important points: First, the Fed will hold to its original 2 percent inflation target, and second, any pause in the pattern of rate increases shouldn't be taken as a signal that policy has changed or is likely to reverse soon. On economic prospects, if the New York Fed research is right, policymakers have much to do to devise a system with less risk and greater financial stability.