Prepare for an Unsettling Monetary Tightening Cycle

If you were born after 1980, the monetary tightening that the Fed said this week will begin in March will be unlike any you’ve seen.

This is for two reasons, both unsettling for markets. First, when the Fed began raising interest rates in 1994, 1999, 2004, and 2015, inflation was near or below its desired level (now formally enshrined as 2%). The tightening was thus pre-emptive, intended to keep inflation from going up rather than to push it down. That gave the Fed considerable latitude about how fast to raise interest rates and how to respond to new data.

Today, inflation is too high. Even if December’s 7% rate is adjusted for temporary effects such as higher oil prices and used-car shortages, underlying inflation is well above 2%. With unemployment at 3.9% and falling, the economy is at maximum employment, putting upward pressure on inflation. This is normally where the Fed wants the economy to be when it finishes tightening, not when it starts.

To temper elevated inflation, Federal Reserve Chairman Jerome Powell said the central bank intends to raise short-term interest rates in mid-March. Photo: Federal Reserve

The Fed is thus so far behind the curve that it needs to get interest rates up almost irrespective of what incoming data say about the economy or inflation.

The second way this cycle will be different became clear during Chairman Jerome Powell’s press conference Wednesday: The Fed won’t hold the market’s hand by committing to a particular path of rate increases.

Under then-Chairman Alan Greenspan, the Fed first used forward guidance in 2004 when it said rates would rise “at a pace that is likely to be measured.” The goal was to not roil markets with surprise monetary policy moves. The Fed proceeded to raise rates by a quarter-point per meeting.

In 2016, then-Chairwoman Janet Yellen used a reformulated version of the phrase: Economic conditions “will warrant only gradual increases” in rates. The Fed tightened at every other meeting.

After slashing interest rates to near zero at the start of the pandemic, the Fed promised to be even more leisurely about raising rates. As recently as last March most Fed officials thought they wouldn’t start before 2024. They have been revising that schedule ever since, and with this week’s meeting they virtually abandoned it.

Markets have been assuming the Fed would raise rates at every other meeting as it did in its last cycle. On Wednesday, though, Mr. Powell refused to ratify that view. “It isn’t possible to sit here today and tell you with any confidence what the precise path will be,” he said. “Making appropriate monetary policy in this environment requires humility, recognizing that the economy evolves in unexpected ways. We’ll need to be nimble so that we can respond to the full range of plausible outcomes.”

He strongly hinted, though, that the rate path would be steeper, repeatedly noting growth is stronger and inflation much higher than in 2016 to 2018. He called the risks two-sided but only mentioned one side: higher inflation.

While the Fed won’t be holding the market’s hand as in the past, forward guidance isn’t dead. Officials will continue to release projections of interest rates and other economic variables at every other meeting. But Mr. Powell has previously played down their significance, and indeed last month’s projection of three rate increases in 2022 is already obsolete.

It’s been a long time since markets had to grapple with a Fed behind the curve and unwilling to commit to an interest-rate path. It’s a recipe for unpleasant surprises, more market volatility and a risk premium in the form of higher bond yields or lower stock-market valuations.