Fed in a Corner

The sell-off in the Treasury and stock markets may force the Fed to adjust its monetary policy at the March 16-17 FOMC Meeting.  The run-up in yields and drop in stocks, if left unchecked, could undermine the economic recovery.  The immediate question is whether the market sell-offs have to continue up to the Meeting in order to convince the Fed to move.

Fed Chair Powell and other Fed officials have continued to downplay recently rising prices as transitory and have restated their goal to let inflation rise moderately above their 2% target until full employment is achieved.  This was the import of Powell's and Fed Governor Brainard's talks this week.  However,  the Treasury market sell-off is a vote of no-confidence that this policy approach will be accomplished without stoking a significant increase in trend inflation.  It suggests the Fed's policy approach was unrealistic -- even if currently higher prices are temporary, keeping rates low would be undermined by market reactions to hints of a speedup in inflation.

Some Street economists argue that the Fed should implement an "operation twist," raising short-term rates and increasing their purchase of longer-term Treasury securities.  Even if small, this action could stabilize the markets, as it would signal the Fed will not let inflation run away.  This policy shift would lift the dollar and pull down commodity prices.  The balancing of higher short-term rates against lower longer-term yields would mitigate any drag on the economy.

The Fed could justify an operation twist in the context of its stated intentions accordingly.  It could say the offsetting dual impacts on the Treasury market are essentially neutral in terms of the economy, so that monetary policy remains highly supportive.  Officials could get solace from thinking the new fiscal stimulus will more than make up for any residual net drag from the policy.   

From a broader perspective, there is another justification for a change in policy approach now.  The Fed's current approach to achieving full employment relies on a straight-forward path.  It promises to keep rates low and asset purchases high until the economy fully recovers.  Sometimes,  however,  a successful policy requires deviations from such a path.  Overly easy policy now could require overly tighter policy later, making any economic recovery short-lived.  Policy may need to be tightened at times along the way to ensure a long period of economic expansion.  A policy adjustment at the March FOMC Meeting could be interpreted along these lines, thereby making it a stock market positive.