Submitted by Joseph Carson, former chief economist at Alliance Bernstein
The Federal Reserve's new policy approach is that policymakers want to see "actual progress, not forecast progress" before deciding to change its policy stance. Substantial actual progress is occurring in the economy, some places faster than others. How much monetary accommodation is needed to meet the ultimate employment and inflation objectives is debatable. But it is less than when the pandemic started and less after the passage of $1.9 trillion in federal stimulus.
Determining when a policy stance has become too accommodative is not an easy matter—but enabling excessive risk-taking to become well-entrenched is comparable to past policy mistakes by allowing a build-up of inflation and inflation expectations. Both are difficult to unwind, and past episodes have shown it is impossible without triggering significant adverse effects in the economy.
Evidence of Actual Economic Progress & Excessive Risk-Taking
Employment and Jobless Rate: In March, payroll employment increased 916,000, far above market expectations, bringing the three-month job gains of Q1 to 1.6 million. The strong string of monthly job gains helped lower the jobless rate by 0.7 percentage points, from 6.7% to 6.0%.
Job gains in Q2 could easily double Q1 numbers. The rapid increase in vaccinations, enabling the many parts of the economy to re-open, especially travel and schools, will trigger outsized solid job gains. By mid-year, the jobless rate could drop a whole percentage point to 5%, getting very close to the Fed's year-end target of 4.5%.
Does it make sense to maintain the same monetary accommodation scale with the jobless rate at 5% as when it was 10% one year earlier?
Manufacturing, Growth & Inflation Outlook: The Institute of Supply Management (ISM) composite diffusion index for manufacturing in March increased 4 points to 64.7%, the highest reading in 37 years. The substantial gains in new orders and production provide hard evidence of rapid economic growth in Q1 and coming quarters.
But there are also signs of more inflation. The prices paid diffusion index at 85.6, off 0.4 points, remained at a relatively high level. A diffusion index does not distinguish between the scale of the gains and declines, so it is unclear how much inflation is in the pipeline. However, purchasing managers listed 57 commodities rising in price (not sure if that is a record number) and 25 items in short supply, which together speak of a broad range of price and cost pressures hitting companies.
Does it make sense to maintain the same monetary accommodation scale from a year ago now that the growth and inflation outlook has flipped?
Inflation & Housing: The Federal Reserve is committed to hitting the 2% general inflation target, but in doing so, they are fueling a fire-storm in the housing market.
The house price index published by the Federal Housing Finance Agency (FHFA) is up 12% in the last twelve months, pushing house prices to record levels. That compares to the 2% increase in the imputed owners' rent used to calculate the consumer price index. The gap of 1000 basis points between actual house prices and implied rents is 200 basis points wider than the gap during the peak of the housing bubble of the early 2000s.
Oddly, policymakers employ the same monetary tools of zero official rates and massive purchases of mortgage back securities today to support the housing market as they did after the housing bubble burst in 2008/09.
How can the Fed justify the same monetary accommodation scale for the housing sector when prices rise at a double-digit pace and when they fall double-digits?
Finance & Risk-Taking: In Q1, the broad equity markets reached record levels, extending the fast gains of 2019 and 2020. Domestic equities' market value has increased 50% or $16 trillion to $48.7 trillion in the past two years. At least one policymaker had acknowledged the dizzying heights of asset prices.
Last week, Federal Reserve Bank of Dallas President Robert Kaplan stated, "There's no question that financial assets, broadly, are at elevated valuation levels." Mr.Kaplan went on to say that he was "concerned about excess risk-taking and if risk-taking goes too far, whether it creates excesses or imbalances, that could ultimately create challenges.."
The Fed's dot plot suggests that policymakers plan to maintain the same monetary accommodation scale for the next three years. That creates a vision of continued gains in equity prices and encourages speculation and excessive risk-taking.
The overly stimulative monetary policy stance is evident in the rapid price increases for residential real estate and financial assets. In the past, policymakers failed to take reasonable steps to head off inflation pressures before they intensified. Nowadays, policymakers need to counter a build-up of excessive increases in asset prices.
A successful monetary policy is to avoid fueling financial and price imbalances that cut short a business cycle and not hit arbitrary jobless and inflation rates. Policymakers need to signal a break in the promise in its easy money policy soon to avoid a boom-bust economic cycle.