Federal Reserve Chairman Jerome Powell. The central bank’s move Wednesday opens up the possibility of an initial rate increase in the spring.
Photo: Andrew Harnik/Associated Press
The Federal Reserve might be on its way to making a mistake, but it is hard to know in which direction.
The Fed on Wednesday set the stage for raising rates earlier and by more next year than it had previously expected. Its move to wrap up its bond purchases by March opens up the possibility of an initial rate increase in the spring, and its projections now show policy makers expect to raise their target range on overnight rates by 0.75 percentage point by the end of next year, whereas they were previously split on whether to raise rates at all.
There are two big reasons for the shift: The first is that the rise in inflation hasn’t been as fleeting as the Fed thought it would be, with the supply-chain problems that have been pushing up goods prices in particular persisting. The second is that despite heady demand for workers, many people have yet to re-enter the labor market. That is lifting wages and, to the extent that companies are able to pass their costs on to consumers, could add to overall inflation.
One obvious risk is that three quarter-point rate increases over the course of next year won’t be enough to cool inflation. Maybe waves of new coronavirus variants keep bottlenecks from clearing, for example, or maybe people continue to resist going back on the job hunt, and wage pressures increase further. Maybe higher inflation becomes so ingrained in consumer expectations that it is hard to put back in the bottle.
In that case the Fed will be in a situation in which it keeps having to reset its rate expectations higher—an especially worrisome outcome for investors, because historically when the Fed has gotten behind the curve on rates, it has tended to tighten to the point that the economy eventually stumbles.
The other risk is that the Fed is running out of patience too soon. Lately, there have been indications that supply-chain problems are lessening, while the November employment report showed an influx of people coming into the workforce. Households don’t look as if they are going to get another round of government relief payments in 2022, taking away what has been an important source of demand. Both inflation and the economy could be cooler than the Fed anticipates.
The best outcome is that the Fed, with its reset on Wednesday, is getting things just right. The worst is that the Omicron variant unleashes a wave of Covid-19 cases that does so much economic damage that it makes the notion of raising rates next spring a complete nonstarter. Fed policy mistakes are a worrisome possibility, but there are even more frightening scenarios.
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Appeared in the December 16, 2021, print edition.
