Recently, the Cleveland Federal Reserve Bank President, Loretta Mester, made remarks in a speech at the International Research Forum on Monetary Policy. These remarks indicated that the current policy stance of the Federal Reserve is “the great recalibration of U.S. monetary policy.” She’s only the latest one to make such comments, suggesting that other experts feel the same way, that this “recalibration” is soon coming.
Here, I’ll talk more about her particular speech, the areas called out in it that suggest a great recalibration of U.S. monetary policy, and what it means for U.S. consumers.
What Does Recalibration Mean?
By definition, “recalibration” means to readjust something by determining the deviation from the standard and making precise adjustments for a particular function. Regarding the Fed’s monetary policy, this “recalibration” would mean a tightening that would try to combat the current inflation.
We can already see it starting with the recent rapid and sharp increase in interest rates. In other words, assets are being “re-priced” to reflect a more normal monetary policy/interest rate level. According to Mester, the recalibration started last year in the autumn of 2021, when it began tapering asset purchases. By March 2022, asset purchases had ended. The Fed also started in June 2022 to reduce their balance-sheet assets[1].
How Inflation Created the Urgency
Part of the urgency for recalibration comes from the current situation of the highest inflation readings in the U.S. in over 40 years. To read more about the CPI, the measure used to back this statement, HERE. This situation has placed tremendous pressure on the Feds to do something to get it under control. One of the challenges the Feds must address is bringing the excess demand into balance with a supply that still faces constraints. This supply and demand imbalance occurs in both the product and the labor markets.
Even though the U.S. economy added 6.7 million jobs last year, the labor market continues to remain very tight. Studies show that for every unemployed worker, two job openings exist. However, for some reason, they just can’t be filled. This is reflected with the currently low labor force participation rate, which is keeping the unemployment rate artificially low. Labor supply just cannot keep up with demand, and it’s causing strain on the economy. Additionally, prices and wages have both moved upward, but they are still inconsistent with maintaining price stability. More on this is discussed with a lecture given by Fed Governor Christopher J. Waller which can be found HERE.
Rising Chance of Recession
According to Beth Ann Bovino, chief economist for S&P Global, the probability of a recession occurring over the next year is currently around 35%[2]. In fact, it seems almost impossible at this point to reduce inflation to the long-term goal set by the feds of 2 percent (in March of this year, it was over 6.2%) without initiating a recession in the process.
However, the Fed has indicated that a recession in the U.S. is an acceptable cost if they can rein in inflation as the end result, and chances are the recalibration will unfortunately not be able to occur without one.
How Will a Recalibration of U.S. monetary policy Help the Economy?
Undoubtedly, the Fed will attempt to use their monetary policy to get inflation under control, or at least imply to the market that that is their intention. However, it will likely take a bit of time to reach the long-term goal of 2 percent. Monetary policy unfortunately cannot affect supply chain factors, especially for commodities. The continuing war in Ukraine and the zero-COVID policies in China continue to disrupt supply chains and are things the Feds cannot do anything about directly. The only major thing the Feds can do regarding this supply and demand imbalance is to decrease consumer demand for these types of things. They do that through the re-pricing of money (i.e., higher interest rates) with the stated goal that those higher rates slow inflation.
One example where many American consumers see this re-pricing in action has to do with the cost of mortgage borrowing. At the beginning of 2022, rates for a 30-year mortgage were around 3.25%. At the time of this writing, rates now average at about 5.3%, marking the sharpest increase in about 20 years. As a result, mortgage applications are starting to decline.
Mester contends that the Federal Open Market Committee (FOMC) must be “resolute and intentional in removing policy accommodation at the pace needed to get inflation under control.” She stresses that they will need to shift from the accommodative policy needed early in the pandemic to one that can face the current critical challenges of the U.S. economy. If they do that correctly, inflation should trend downward and eventually reach the 2 percent goal.
What Else Needs to Stay On Track?
The other suggestions for the FOMC that Mester made during her speech to lay out a path for success with the recalibration of the U.S. Monetary Policy include:
- Increasing the Fed funds rates and raising the policy rate another 50 basis points at each of the next two meetings.
- Continuing to remove accommodations over the remainder of the year.
- Calibrating the policy to bring demand better in line with supply, therefore putting inflation on a downward trajectory.
- Implementing balance sheet reductions for the Feds by adjusting the reinvestment amounts of the principal payments the Fed receives on assets (initiated in June 2022).
- Considering asset sales after balance-sheet reduction is underway.
She indicated that if by the September FOMC meeting, the monthly readings on inflation show that inflation is moving down, there will be an opportunity for the pace of the rate increases to slow. However, if it does not show that, they may need a faster pace of rate increase. Regarding the reduction of the size of the balance sheets, they will monitor developments in money markets to determine the appropriate level of reserves at which to end the balance sheet run-off.
The End Goal of the Great Recalibration of U.S. monetary policy
We can gather from Mester’s speech that recalibration (or normalizing the monetary policy) is necessary. The economy cannot survive with the accommodations that the Feds put in place at the start of the pandemic.
If we look back, at the start of the pandemic, the Feds reduced the target range of its policy rate to 0 to ¼ percent. They also used the balance sheet as a policy tool, buying large quantities of treasury and mortgage-backed securities. Those steps were believed to be necessary to reduce the financial strains during that time and support the economy.
However, as indicated by the current inflation levels, these accommodations no longer effectively support the economy. Or at least, these accommodations are no longer politically palatable. Consumer price inflation is not directly tied to monetary policy; however it can be influenced by it. A worthy counterargument is that the consumer price inflation seen the past couple years has been primarily due to supply constraints and other structural issues in the real economy. Monetary policy directly influences the financial economy (financial assets), this accommodative monetary policy must be routed into the real economy through some other mode (normally commercial bank lending or government transfer payments). Ultimately, consumer price inflation is a reflection of more dollars appearing on the balance sheets of entities in the real economy (individuals buying goods and services).
Regardless, it is believed that the Fed can control consumer price inflation so therefore, they must act as if they are working to bring inflation back down to their target.
[1] Loretta J. Mester, “The Great recalibration of U.S. Monetary Policy”, (speech) https://www.clevelandfed.org/en/newsroom-and-events/speeches/sp-20220513-the-great-recalibration-of-us-monetary-policy.aspx
[2] A. Bhattarai, “U.S. may be barreling toward recession in next year, more experts say” The Washington Post, May 19, 2022. https://www.washingtonpost.com/business/2022/05/19/recession-economy-markets/
