The Federal Reserve made four crucial mistakes that has allowed inflation to soar and will result in more interest rate hikes that markets now expect, said former New York Fed President William Dudley on Monday.
Fed Chairman Jerome Powell will discuss the Fed’s performance on Tuesday when he testifies to the Senate Banking Committee considering his nomination for a second four-year term.
And on Wednesday, the magnitude of the Fed’s challenge taming inflation will come into focus as economists expect the government to report that consumer price inflation index soared above a 7% annual rate in December.
The seeds of the Fed’s woes started in the fall of 2020 when the Fed adopted a new framework to allow inflation to overshoot its 2% target for a time to make up for past periods of low inflation.
The first mistake, Dudley said, was how the Fed “operationalized” this framework. The central bank promised they would not lift the benchmark interest rate from zero until it saw 2% inflation for at least a few months and full employment was reached.
“That means a starting point for monetary policy liftoff is when the economy’s already overheating,” Dudley said.
Dudley’s comments came in an op-ed on Bloomberg News and a subsequent interview. He served as the president of the New York Fed from 2009 until 2018.
The Fed’s second mistake was in misjudging the strength of the labor market, Dudley said.
For months, Fed officials downplayed signs of a tight labor market – instead highlighting that participation in the labor market was lagging.
“I think they were surprised by how fast the labor market tightened,” Dudley said.
Tight labor markets have now translated into wage growth is now faster than the rate consistent with the Fed’s 2% inflation target, Dudley said.
“So even if you think that the initial impulse and inflation turns out to be transitory, you now have a problem because the labor market is sufficiently tight that wages are going to continue to accelerate,” he said.
The third mistake the Fed made was to view inflation as “transitory,” he said.
“I think a lot of the inflation pressures we’re seeing are transitory but it’s lasting for a lot longer and a lot higher rate than they anticipated,” he said.
The final mistake was the Fed was too worried about spooking the bond market and causing another “taper tantrum,” Dudley said.
“I think they were a little bit too gentle in terms of their communication to financial markets because they were worried that would provoke a sell-off in the bond market. I think the problem right now is that the markets aren’t taking them seriously enough,” Dudley said.
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Dudley thinks the Fed will start to raise its benchmark rate four or five times this year and ultimately have to raise it benchmark rate to 3%-4%.
