Next year will test whether the new approach to monetary policy recommended by advocates and embraced by central banks actually works. The stakes are high. The labor market appears to be recovering—unemployment is down to 4.2 percent—but inflation, by last estimate, was 6.8 percent. Normally, it would be time for the Fed to step in with sharp rate increases. Yet nominal interest rates are still near zero and the Fed is still buying long-dated assets—supposedly an emergency measure, taken when the market was under extreme pressure.

This week, the Fed announced a course change. It will buy fewer long-dated assets, in order to phase out the emergency program faster. And it has planned several small rate increases starting next spring, with the policy rate scheduled to hit 2.1 percent by 2024. “You’ve seen our policy adapt, and you’ll see it continue to adapt,” said chairman Jay Powell. But appearances notwithstanding, the policy remains strongly accommodative. Even after all the rate hikes, real (that is, inflation-adjusted) rates will still be negative for the next few years.

Facing the first major inflation threat in a generation, the Fed is mostly counting on talk rather than action to tame it. The view on how to conduct effective monetary policy without blowing up the economy is always evolving—or, depending on how you look at it, moving in circles. Currently, the prevailing view is that expectations are what matter. Thus, if the Fed signals it will raise rates in the future, that can be almost as powerful as raising them today. That may sound ridiculous, but it does make some sense, since inflation expectations drive long-term inflation: people negotiate wages and make pricing decisions based on what they think will happen. As long as people believe the Fed is committed to tackling inflation, the expectation can become self-fulfilling.

Of course, for the Fed to be credible, it has to follow through. Odds are it will—unless, of course, another crisis arises in the next two years. And for expectations to become reality, people also have to believe that the Fed’s plans to curb inflation will be sufficient to the task. If inflation remains elevated two years from now—at, say, 4 percent—then real rates will still be largely negative, at just above negative 2 percent.

Powell apparently hopes that talk about future small rate increases will allow him to avoid resorting to big hikes. Large rate increases not only threaten the labor market and risk a recession but also can undermine financial stability, since financial markets have become accustomed to very low rates. The plan may work—but throughout history, inflation has been hard to curtail without some economic pain.

Unfortunately, evidence is scarce on whether setting expectations can work. The economy has not experienced high inflation for a long time. Elsewhere, other central banks are taking a more aggressive tack: the Bank of England is increasing rates, for example. Time will tell which approach is more effective.

Photo by Alex Wong/Getty Images


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