Retake on Double Take: Behind Fed doors

A common factor that influenced many 2024 investment outlooks was a basic set of questions regarding US Federal Reserve (Fed) interest-rate cuts: How many? How deep? When?

But what about the ‘why?’ of the Fed’s all-important interest-rate decisions? On a recent episode of Double Take, Jeffrey Lacker, former president of the Federal Reserve Bank of Richmond and former member of the rate-setting Federal Open Market Committee (FOMC), dug into the mechanics of how the Fed arrives at rate decisions, and what the biggest considerations are in that decision.

According to Lacker, while the inflation rate is the key starting point in deciding interest rates, the Fed’s calculus gets significantly more nuanced from there, and has been in a subtle state of flux in recent years.

Nowadays the key thing they are looking at is the inflation data. And there, you have got food and energy that tend to flop around and be more volatile, so there is a look at the core inflation rate. And then within the core inflation rate, there are some funky things going on with housing. The way housing inflation is measured is a little peculiar and gives the housing component of the price indexes some weird properties. And I think the Fed lately, in the last few years since the pandemic, has stripped out housing to try and get away from that … For monetary policy purposes, inflation is it. But for growth and real outcomes, I think that vacancies and unemployment, that ratio is very important. That is a measure of the tightness of the labour market. So when there are a lot of job postings that are vacant and not many unemployed, that is a very tight market. We have had a really tight job market for a couple of years now since we started recovering from the pandemic. So that would be a key indicator for me.

Jeffrey Lacker, former president of the Federal Reserve Bank of Richmond

Lacker, who participated in FOMC meetings from 2004 to 2017, believes Fed culture has evolved to a position where the chair discourages members from expressing public dissent with policy. This threat of opposition is the leverage committee members need to sway the Fed’s position.

I took seriously that this is a deliberative body, like the Supreme Court, where you express exactly what you think and vote accordingly. Now there is a different philosophy floating around. I think the committee in recent years has moved, under Chairman (Jerome) Powell, has moved toward a philosophy that is more like a corporate board, where you can dissent internally, but externally you all stick to the company story. I think that is a little unfortunate, but it seems like that is the culture they’re moving towards with regard to dissent. So dissents have fallen off in the last decade or so, and I think it is a mistake.

Jeffrey Lacker

In Lacker’s opinion, the Fed erred in identifying post-pandemic inflation as transitory because it misinterpreted the factors causing supply-chain disruptions and “overestimated the slack in the economy.”

So the unemployment rate is the thing people look at often, and that was trending down, but it is an imperfect indicator of slack, because it takes time for people, who have been laid off in one sector of the economy or who have voluntarily quit one job, to find the job that’s right for them. It is a costly search effort. And that can mean that there is not room to increase employment rapidly, because it would be too hard to find ways to reallocate workers across sectors … in early 2021, the big shock to the economy was a huge burst of dollars in the hands of consumers and businesses, and the strong interest in spending it. And that was going to lead to a bottleneck somewhere. The fact that supply got disrupted for separate reasons, it meant that there was an imbalance between demand and supply, and whether the disruption comes from a bulge in demand or a diminution in supply is immaterial. At the end of the day, you are going to have inflation unless you raise real interest rates and encourage people to spend over a longer horizon. So, I think they misinterpreted the shock, misinterpreted how much slack, unused capacity there was in the economy, and then there were some problems with the expectations they had set up in the previous year about how they would conduct policy.

Jeffrey Lacker

In an election year, Fed independence is a hot topic. The Fed operates independently of the legislative and executive branches, but its mission can be influenced by the actions of Congress and the President. Therefore, they need to communicate regularly and clearly.

Lacker claimed that previous cases of the executive branch interfering to lower interest rates before an election led to inflationary pressures that burst soon after the winner was sworn in. He cited an instance in 1972, where a Fed chair partial to President Richard Nixon agreed to a program of price controls. Although these kept interest rates low, providing stimulus and lowering unemployment, the restrictions built up inflationary pressures that exploded after the election.

It helped (President Richard) Nixon get re-elected, but then we had the worst inflation that we have had since World War II … Since then, I think the lesson about political independence has been learned quite well. I think the cauterising effect of the 1970s inflation, which was a disaster for the Fed and the country, I think has taught policymakers both inside and outside the Fed that, yes, succumbing to partisan political pressure is a huge mistake. We do not want to run the country that way. So, the Fed will bend over backwards to strike a pose of non-partisanship, even if behind the scenes it might be more friendly to some party’s policy proposals than other party’s policy proposals and points of view, they will strive to be neutral. And in interest rate setting, in macroeconomic policy setting, they will pursue what they think is best for the economy … I do not think they are at risk of flooring the accelerator and just incurring inflation risks after the next election.

Jeffrey Lacker

In Lacker’s view, the economic conditions that sway elections are set two to three quarters before election day; thus, the data that comes over the summer months tends to not have much of an influence on the election outcome.

By the time you get to March, that stuff is baked in and you don’t have that much leverage to influence, through monetary policy, the economic outcomes in a way that is significant enough to really influence the vote. So, again, we just stuck to, in my experience, all my colleagues just stuck to what is best for the economy over the longer run, looking through the election.

Jeffrey Lacker

From Lacker’s point of view, since inflation is about 3%, he anticipates the Fed will maintain its restraint until it sees inflation dropping to 2.5% or 2.25%.

I would err on the side of hanging tight until you see that, and I think that is why you’ve seen so much pushback on market pricing over the last month or two. You have seen the Fed, Fed officials really push back on the huge number of expected rate cuts that the market priced in. I think they had to try and reel that in just to align market expectations with reality.

Jeffrey Lacker

To hear more, subscribe to “Double Take” on your podcast app of choice or view the Behind Fed doors episode page to listen in your browser.

Authors

Jack Encarnacao

Research analyst, investigative, Specialist Research team

Raphael J. Lewis

Head of specialist research