The Fed's Dilemma: Which "Curve" Should It Target?
The Fed is in a pickle. Traditional and unconventional monetary tools have altered the signaling effect of two critical indicators: the market yield curve and the economy's growth curve. The Fed's bond-buying program has created an anchoring effect on the long-end of the Treasury curve, distorting the market yield curve signal. At the same time, the Fed maintaining policy rates at zero against the fastest nominal GDP growth in nearly 40 years has created the steepest economy's growth curve on record. Which one should the Fed target to achieve its inflation mandate?
Policymakers and many analysts believe the slope of the market yield curve, or the spread between the two-year and the 10-year treasury yield, is a powerful forecasting tool due to its consistent and reliable track record. Yet, the economy's growth curve, or the spread between the federal funds rate and nominal GDP, has a track record equally good.
The economy's growth curve essentially captures borrowing costs relative to Nominal GDP/income growth. History shows that when the Fed keeps borrowing costs running well below the economy's growth rate, it helps maintain robust consumer and business demand, creating the potential for a cyclical rise in inflation. (Note: the cyclical jump in consumer price inflation was most evident from the 1960s to the early 1980s when the CPI included house prices and less noticeable in the reported figures after BLS changed its measurement process in the 1980s and the data sampling in the late 1990s. Measured the old way, CPI inflation in 2021 would equal the high readings of the 1970s.)
In 2021, Nominal GDP increased by 10%, while the Fed kept the federal funds rate near zero. That resulted in the steepest economy's growth curve on record and put the Fed in an unprecedented weak position attempting to reverse the inflation cycle.
It's hard to imagine a scenario where the Fed can change policy rates to narrow that gap quickly. Even if the Fed raises official rates eight times, 25 basis points each, to 2%, in 2022, and reported inflation halved, that would still leave the monetary policy stance far too easy relative to Nominal GDP.
So the other option for the Fed is to fight inflation through the traditional yield curve and asset purchase program. The Fed could flip the yield curve (i.e., invert it) and trigger an economic slowdown through the financial markets/portfolio channels by raising official rates faster and more than the financial markets expect. That would start a substantial decline in asset prices and a negative wealth effect. Alternatively, policymakers could decide to shrink its balance sheet by selling long-dated Treasures, lifting bond yields in the process. That, too, would result in a substantial asset price decline.
It's hard to see any successful strategy reducing inflationary pressures that do not include a substantial and sustained decline in asset prices.