Jerome Powell faced his toughest test yet—and he passed it.
Last week, the head of the US Federal Reserve had the sensitive task of announcing the central bank is rolling back its bond-purchasing program, a key prong of its pandemic stimulus. Back in 2013, in the wake of the Great Recession, then Fed chair Ben Bernanke triggered a bond sell-off and a surge in yields by just floating the idea of tapering its bond buying, an incident dubbed as the “taper tantrum.”
This time around though, Treasury yields didn’t blink when Powell informed markets the central bank is reducing its $120 billion in monthly bond purchases at a pace of $15 billion each month.
That’s in large part because Powell (with the help of other members of the Federal Open Markets Committee) started communicating about tapering months ago. And when the moment to announce the decision came, he was clear on how the central bank intends to balance its continued support of the economy with rising inflation, calming market jitters about its ability to successfully do both.
“An increasing number of inflation hawks, economists, and former Fed officials are saying that the Fed is behind the curve,” said Claudia Sahm, a former Fed economist. “Powell patiently explained why the Fed’s policy is appropriate now, despite temporarily high inflation, and that it is nowhere near raising interest rates.”
Fed chair Powell’s Great Recession lesson
Powell wasn’t always this dovish about inflation. In 2013, during his first full year on the board of governors, he sided with hawks who argued for tapering at a time when most economists now agree was too early, a move that likely contributed to the drawn-out recovery.
“Powell looked at the fact that unemployment fell much lower than Fed researchers told him it was going to fall and realized we actually should have been more expansionary back then,” said Scott Sumner, a monetary economist at the Mercatus Center at George Mason University. “Like there was a lot more room to grow than we thought.”
And it’s not just Powell. The change in tack reflects the evolution in the Fed’s overall approach to monetary policy, and a shift in its understanding of the US economy.
Given what we know now about the Fed’s mistakes, Sumner thinks Bernanke would have done the same thing as Powell. “Bernanke after he left the Fed advocated for a policy pretty similar to what the Fed is doing now,” Sumner said.
Delinking Fed’s taper from interest rate hikes
Powell also seems to have taken in the lesson that a key step to avoid a rise in bond yields (the “tantrum” part of the taper tantrum) is making sure the market doesn’t try to guess when interest rates will be hiked after tapering.
Bernanke addressed interest rates a month after he first brought up scaling back bond purchases, saying the rollback did not mean an interest rate increase was about to happen. But the negative shock was already working its way through markets and hurting foreign investors in emerging economies who were dependent on capital flows from the US.
Last week, Powell “could not have been clearer” on this point, Sahm said. The Fed chair said raising interest rates was not even a topic of discussion during the latest FOMC meeting. The test for raising rates is “different and more stringent,” he added.
Interest rates timeline will follow the pandemic’s path
Powell didn’t offer a firm timeline for interest rate hikes, reiterating that the path of the pandemic will determine that of the economy. “I think we’re learning that we have to be humble about what we know about this economy, which is still very covid-affected,” he said.
The call for humility signals the Fed isn’t on a preset course when it comes to the US recovery, Sahm said. This is good news for the US because it means the central bank isn’t wedded to its current views of the economy and can adjust course as needed, she added. After the Great Recession, Fed officials raised rates too quickly because they misjudged how much employment could increase without sparking inflation, a mistake they admitted in retrospect.
On Wednesday, Powell pointed out how pandemic-induced snags in the economy have already forced the Fed to reassess its assumptions. “We thought that the schools reopening and lapsing unemployment benefits would produce some sort of additional labor supply that doesn’t seem to have been the case,” he said. “We don’t think it’s a good time to raise interest rates because we want to see the labor market heal further.”
Future lessons for the Fed
Some say Powell’s approach could use some touch-ups. For example, he could provide a better explanation of why the Fed has one standard for tapering and another for interest rates, said Steven Kelly, a research associate at Yale University’s Program on Financial Stability, which focuses on understanding financial crises.
“The Fed does not have a coherent reason for why its asset purchases are not subject to the same test as raising rates,” he added. “The Fed has not said explicitly why we’re taking a long time on rates, but we need to taper now.”
Overall, though, Powell has largely avoided the mistakes of the past. “The Fed has done a great job really all year, saying hey, this has little bearing on our short-term interest rate policy,” Kelly said.