Initially, the Fed was slow to deal with inflation and passed it off as transitory. But as high inflation continued, the Fed has been forced to act more aggressively.6 For now, it appears content to whack stocks and bonds lower, slow the housing market, and weaken the labor market all in an effort to win the fight against elevated inflation. So far, there has been little tangible progress in terms of the labor market or inflation. The unemployment rate currently sits at a fifty-year low of 3.5%.7 The September reading of the Consumer Price Index (“CPI”) shows inflation up 8.2% year-over-year - only down slightly from a high of 9.0% in June. Core CPI, which excludes volatile food and energy components, popped and is now up 6.6%.8 This represents a new cycle high for Core CPI, which means the Fed will keep playing Whac-A-Mole.

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The roots of current inflation trace back to the August 2020 Jackson Hole Economic Symposium. Inflation had remained below the Fed’s stated target for more than a decade (from the Global Financial Crisis in 2008 through the emergence from the COVID-19 crisis). At that meeting, Jerome Powell formally stated that the Fed was moving away from its mandate of a 2% inflation target in favor of average inflation targeting:

 

“Inflation that is persistently too low can pose serious risks to the economy. We will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time. Our approach could be viewed as a flexible form of average inflation targeting. The revisions to our statement add up to a robust updating of our monetary policy framework.”9

 

This was not the first time a Chair of the Fed lamented structurally low inflation. At her final news conference as Fed Chair in December 2017, Janet Yellen made the following statement:

 

“What’s on my ‘undone’ list, you ask? We have a 2 percent symmetric inflation objective, and, for a number of years now, inflation has been running under 2 percent. And I consider it an important priority to make sure that inflation doesn’t chronically undershoot our 2 percent objective, and I want to see it move up to 2 percent. So most of my colleagues and I do believe that it’s being held down by transitory factors, but there’s work undone there, in the sense—we need to see it move up in line with our objective.”10

 

To counteract these low levels of inflation, the Fed kept interest rates at 0% and allowed its quantitative easing (QE) program to double in size to $8.4 trillion worth of U.S. Treasury bonds and mortgage-backed securities.11 Even though QE had been in place since the 2008 financial crisis, it was used to an exponentially greater degree to handle the financial consequences of the pandemic, including crashing markets and massive deficits. These asset purchases help ease financial conditions, improve liquidity, and support economic growth via higher asset prices.12

 

The Fed was slow to react to elevated inflation, which it viewed as transitory.  As a result, it maintained its extraordinary accommodation plan into 2022, even when CPI rose to nearly 7% on a year-over-year basis, a thirty-year high, in November 2021. By the time the Fed raised interest rates by 25 basis points in March 2022, CPI had risen to nearly 8%.13 In June, the Fed then introduced quantitative tightening (QT), a reversal of its widescale bond purchases. To date, however, the Fed’s balance sheet has only been trimmed by $158 billion (or 2%), and it remains higher than it was at the start of the year.11 Interest rates have now reached 3.25%, and additional increases are expected.14 As a result of the Fed’s rapid and significant policy shifts, this has now become one of the most aggressive tightening cycles in history.

The Fed has also used its rhetoric strategically this year, especially since the July FOMC meeting. In that meeting’s press conference, what was either a miscommunication by Powell due to an unscripted response or a misunderstanding from a market desperately reaching for good news, a powerful rally materialized that was fueled by hopes that the Fed was close to changing its policy stance.

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“I’d start by saying we’ve been saying we would move expeditiously to get to the range of neutral. And I think we’ve done that now. We’re at 2.25 to 2.5 percent, and that’s right in the range of what we think is neutral.” 15

 

But this was not what the Fed wanted. A rally in risky assets meant that commodity prices went higher, credit markets eased, and growth expectations drifted up, all factors that would intensify, rather than alleviate, inflation. Powell had inadvertently given markets hope that the Fed would pivot more quickly than it intended. Soon after, Fed officials tried to disabuse investors of their hopes. In an interview with the New York Times two days after the July FOMC press conference, Minneapolis Fed President Neel Kashkari responded:

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“I’m surprised by markets’ interpretation. The committee is united in our determination to get inflation back down to 2 percent, and I think we’re going to continue to do what we need to do until we are convinced that inflation is well on its way back down to 2 percent — and we are a long way away from that. I don’t know what the bond market is looking at in reaching that [pivot] conclusion.” 16

 

At that point, the Fed could not afford for financial conditions to ease when it was trying diligently to lower inflation. Nonetheless, stocks and bonds continued to rally into August. While the risk-on environment ended just before Jackson Hole, markets turned decidedly lower after the no-pivot speech by Powell on August 26. The Fed had not been pleased by the market rally, and it welcomed the market downturn, as Kashkari emphasized soon after Jackson Hole:

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“I certainly was not excited to see the stock market rallying after our last Federal Open Market Committee meeting, because I know how committed we all are to getting inflation down. And I somehow think the markets were misunderstanding that. So, I was actually happy to see how Chair Powell’s Jackson Hole speech was received, people now understand the seriousness of our commitment to getting inflation back down to 2%.” 17