Is the Fed fueling inflation?
Yes, argue Buiter and Sibert. And this is because the Fed’s monetary-policy stance should be restrictive and not neutral, according to the authors of this commentary. In particular, the contemplated two additional 50-bps increases will bring the policy rate to 2%, below the consensus estimate of a 2.5% neutral rate. In addition, the Fed’s balance-sheet tightening is also minimal: the Fed’s balance sheet was at $9 trillion by the end of March 2021 and at the current pace of reduction, returning the balance sheet to where it was in early March 2020 (about $4.2 trillion) will take more than four years.
Central Banks Are Still Far Behind the Inflation Curve
By: Willem H. Buiter, Anne C. Sibert – Columbia University, Birkbeck, University of London
Why would the Fed be perceived as being “behind-the-curve”?
In this paper, Caballero and Simsek develop a model where monetary policy is the key determinant of aggregate asset prices. Their model explains why the Fed stabilizes asset price fluctuations driven by financial market shocks, but destabilizes asset prices in response to aggregate demand or supply shocks that induce macroeconomic imbalances.
They look at a two-speed economy: a slow and unsophisticated macroeconomic side, and a fast and sophisticated financial market side. Spending decisions are made by a group of agents, namely the households, that respond to aggregate asset prices, or financial conditions, but with noise, delays, inertia, and possibly other behavioral frictions. Asset pricing is determined by a different group of agents, namely the market, who are forward looking, and immediately react to economic shocks and the monetary policy response to those shocks. The central bank, namely the Fed, intermediates between these two sides of the economy to achieve macroeconomic balance: the Fed wants to influence the behavior of households, but it needs to operate through the market. In order to set policy, the Fed needs to forecast future macroeconomic conditions: when the Fed expects aggregate supply to increase or aggregate demand to decrease, it targets higher asset prices. Conversely, when the Fed expects higher demand or lower supply, it sets lower asset prices. Hence the Fed’s beliefs matter.
Disagreements between the Fed and the market also drive aggregate asset prices. The market anticipates excessive policy-induced volatility and demands a policy risk premium, which is especially high at times of macroeconomic uncertainty and disagreements.
Finally, the combination of aggregate demand inertia and belief disagreements provides an explanation for why the market sometimes thinks the Fed is “behind-the-curve” and will eventually reverse course. The Fed’s interest rate decision might have to partially accommodate the market’s belief, even though the Fed does not agree with the market.
A Monetary Policy Asset Pricing Model
Authors: Ricardo J. Caballero, Alp Simsek
From: MIT, Yale University
The equivalence between policy rate hikes and the Fed’s balance sheet reductions
In this note, Crawley et al. highlight the relation between policy rate hikes and balance sheet reductions. They consider three scenarios:
- Baseline: Shrink the balance sheet starting in June 2022, i.e. after a three-month phase-in period, let up to $60 billion in Treasury securities and up to $35 billion in agency MBS run off the balance sheet per month.
- No runoff: Keep the balance sheet size constant in dollar terms by rolling over Treasury securities and agency MBS until growth in the demand for Federal Reserve liabilities provides a basis for resuming organic growth of the balance sheet.
- Full runoff: Shrink the balance sheet through the full runoff of all Treasury securities as well as maturing and prepaid agency MBS starting in June 2022, without any phase-in period (about $105 billion per month, on average over the runoff period).
They argue that their model predicts that reducing the size of the balance sheet by about $2.5 trillion over the next few years, as opposed to maintaining the size at its peak level, would be roughly equivalent to raising the policy rate a little more than 50 basis points on a sustained basis. However, this estimate is associated with considerable uncertainty.
Authors: Edmund Crawley, Etienne Gagnon, James Hebden, James Trevino
From: Federal Reserve Board
