Steady Rates, Shaky Guidance

The Fed held rates steady today, in the range of 3.5 to 3.75 percent. Three (of twelve) Fed officials voted against the move — preferring a quarter-point increase instead.

The lead-up to today’s meeting was unusually dramatic, with markets more uncertain than at any time in recent years about which way the decision would go. As of this morning, they were split roughly 70-30 (in favor of no rate hike).

There were two main reasons for this uncertainty. The first is that it reflects a genuinely difficult choice. Strong arguments could be made on both sides — either for holding rates steady or for a small increase.

But this fresh volatility also stems from a stark change in Fed policy under its new chair, Kevin Warsh.

A genuinely difficult decision

Over the past 18 months, we’ve experienced not one, but two separate supply shocks. We can blame the first on Trump’s trade war, and the second on his war war.

The tricky thing about supply shocks is that they raise the cost of doing business, and so goose inflation and slow the economy simultaneously. The Fed can solve either of these problems — but not both at once.

Still, while supply shocks push inflation higher, the rise should — theoretically — be temporary. They typically cause a one-time increase in costs, and businesses raise their prices to account for the change. Prices stay high, but inflation falls away, and that should be the end of it.

Because of this, the economic textbooks say that the Fed can afford to look through a supply shock and wait it out (i.e., forgo raising rates to fight inflation). As a textbook author myself, I tend to take this textbook idea pretty seriously.

On the other hand, we’ve now been waiting for more than five years for inflation to return to the Fed’s two percent target. At this point it’s reasonable to ask: How much longer can we afford to wait? (This more hawkish stance would suggest raising rates, and it’s usually accompanied by a heaping serving of concern about inflation expectations…