Federal Reserve Chair Jerome Powell has finally delivered his message loud and clear: To get inflation under control, the central bank intends to push interest rates higher, and keep them there longer, than markets had expected. 

It’s a great first step. Now the Fed must follow through.

In his speech at the annual Jackson Hole economics conference, Powell defined the problem concisely: The labor market is too tight, and inflation is too far above the central bank’s 2% target. He was also candid about the required response: Make monetary policy tight enough for long enough to be sure that inflation will fall back to 2% and remain there — an “unconditional” policy that will inflict “pain” on households and businesses. Judging from Friday’s sharp decline in stocks, market participants understood.

Powell’s remarks offered a welcome contrast to previous communications, which left markets wondering how far the Fed would be willing to go in its inflation fight. The minutes from the most recent meeting of the policy-making Federal Open Market Committee, for example, mentioned the risk of over-tightening. And in August, Powell noted that the full effect of interest-rate increases had yet to be felt. This time around, there were no qualifications, no waffling about the goal or what the Fed must do to achieve it.

So what comes next? Words must lead to actions. For one, the Fed’s next set of economic projections need to reflect reality. The forecasts released in June saw short-term interest rates peaking at a mere 3.8%, and inflation falling back quickly toward 2% amid an improbably small increase in unemployment. As Powell warned, interest rates and unemployment will need to be significantly higher, and the path back to target inflation will be longer.

Some public introspection would also be in order. How did inflation get so far away from the Fed’s objective? Was it bad luck, poor forecasting, an ill-suited monetary policy framework, or inadequate implementation of that framework? Only by understanding what happened and sharing its findings can the Fed fully restore its credibility, and make the necessary adjustments to avoid such problems in the future.  

The right answer is all of the above. The bad luck included the coronavirus pandemic, the mutations of the virus, and the Ukraine-Russia war, which generated a series of demand and supply shocks that helped push inflation higher. Forecasts were unduly optimistic about slack in the labor market, the speed with which labor-force participation would recover, and the transitory nature of inflation pressures. The new, more inflation-tolerant monetary policy framework didn’t anticipate an extreme inflation overshoot. And the Fed’s implementation of that framework rendered it unable to remove monetary stimulus in a timely manner.  

The Fed tied its hands in a complex knot. It pledged not to increase short-term interest rates until inflation reached 2% and was expected to remain above 2% for some time, and unemployment had declined to a level consistent with the inflation target. Asset purchases couldn’t end until substantial progress towards these objectives had been made. Even then, the purchases could only be tapered. And they had to phased out completely before interest rates could be raised.

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