Board of Governors of the Federal Reserve System

February 14, 2024

The Federal Reserve’s responses to the post-Covid period of high inflation

Jane Ihrig and Chris Waller¹

In the face of the COVID-19 pandemic in March 2020, the Federal Reserve committed to using its full range of tools to support the U.S. economy. Over the next year and a half, with progress on vaccinations and strong policy support, indicators of economic activity and employment strengthened while inflation moved higher. Faced with a tight labor market and elevated inflation, the Federal Open Market Committee (FOMC) began a process of unwinding the very accommodative stance of monetary policy and moving to a restrictive policy stance to address inflation pressures. Here we review the sequence of actions taken by the Committee between late 2020 and mid-2023 as well as discuss some issues it contemplated along the way; the table provides a chronological list of key events over this period.

To set the stage, the FOMC was using three tools to conduct policy during the worst of the COVID pandemic: the target range for the federal funds rate, balance sheet policy, and forward guidance.^2,3 The target range is the Fed's primary tool, while the other two tools are supplemental. By March of 2020, the target range was at the effective lower bound and the Federal Reserve announced plans to purchase enormous amounts of Treasury securities and agency mortgage-backed securities (MBS) to address severe market dysfunction. By mid-year, purchases were moved to a steady pace of $80 billion per month in Treasury securities and $40 billion per month of agency MBS to provide additional policy accommodation. Forward guidance was used to give the public some understanding of when these policies would be adjusted.

As the FOMC planned for the time when the economy had healed enough to start removing accommodation, it knew the importance of clear and early communications. As a result, in September and December 2020, respectively, the FOMC laid out guidance for raising the federal funds rate off the zero lower bound and for tapering asset purchases. The liftoff statement said that the Committee expected to maintain the target range at the effective lower bound until "labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time."⁴ The balance sheet guidance noted that the Fed would keep buying $120 billion per month in securities "until substantial further progress has been made toward the Committee's maximum employment and price stability goals."⁵

A fair question is, what did these words mean? And, in particular, what did the phrases "substantial further progress" for tapering and "for some time" for liftoff mean? In large part, the interpretation hinged on how the Committee anticipated the economy would recover from the pandemic. Looking across forecasts at the time by Committee participants and the private sector, no one expected substantial progress toward both our goals to happen very soon. At the end of 2020, the economy had begun to recover, but COVID was bad and getting worse, vaccines were just arriving, and no one knew how soon schools would reopen and people would get back to work. In November and December 2020, the unemployment rate was 6.7 percent and inflation seemed to be in check: 12-month personal consumption expenditures inflation was declining, and core inflation, which excludes volatile energy and food prices, was more or less steady at 1.5 percent. The Summary of Economic Projections (SEP) by FOMC participants in December 2020 had the unemployment rate moving down to 4.2 percent at the end of 2022 and inflation moving up to 2 percent only in 2023.⁶ Only one participant had liftoff occurring by the end of 2022.

Based on this SEP, the FOMC participants generally did not expect the economy to recover quickly. And, looking at the Federal Reserve Bank of New York's Survey of Primary Dealers in January 2021, the median respondent thought tapering of asset purchases would start in the first quarter of 2022 and liftoff wouldn't occur until the end of 2023 or later.

To move forward, policymakers had to evaluate "substantial further progress" and "for some time." The phrases, admittedly, are not concrete in their meaning. The Committee did not define how much above 2 percent is moderate and how long some value of elevated inflation should be tolerated. In addition, for assessing progress on the health of the labor market, different policymakers prefer different measures that may not provide the exact same signal. On top of this, the data used to measure progress in the labor market can revise substantially and reshape the evaluation of the strength of this market quite quickly. For example, a key input—payroll data—in the latter half of 2021 painted a picture of a slowing labor market. But revised data over several subsequent months revealed that the slowdown never happened. Instead, job gains were quite robust. In particular, initial reports of job creation between August and December 2021 were a cumulative 1.4 million, but by February 2022 that number was revised up to nearly 2.9 million.

Early in 2021, inflation broke loose. Most of the suspected contributors to this surge in inflation appeared to be temporary: supply-chain bottlenecks that previous experiences suggested would ease soon, a surge in demand for goods, and the second and third Economic Impact Payment checks sent to households. Reflecting this view, the April 2021 FOMC statement pinned the rise in inflation on "transitory factors."⁷ Meanwhile the labor market and other data related to economic activity suggested a healthy economy. In the June 2021 SEP, seven participants had liftoff in 2022 and only five participants projected liftoff after 2023.⁸ Thus, after observing high inflation for only three months, many FOMC participants were moving in a hawkish direction and were considering tapering sooner and pulling liftoff forward.⁹

At the July 2021 FOMC meeting, the minutes show that most participants believed that "substantial further progress" had been made on inflation but not employment.¹⁰ The progress on inflation reflected the fact that some measures of average inflation were moving above, or would soon move above, the Committee's 2 percent goal. Meanwhile, by September, looking at the progress of the labor market since December 2020, a number of participants assessed that the standard of substantial further progress toward the goal of maximum employment might soon be reached. At this point the FOMC stated that if progress continued broadly as expected, that a moderation in the pace of asset purchases might soon be warranted. Based on the incoming data, the FOMC announced the start of tapering at its early November 2021 meeting, reducing the monthly pace of its net asset purchases by $10 billion for Treasury securities and $5 billion for agency MBS.¹¹

Then, the October and November 2021 consumer price index reports showed that the deceleration of inflation from April to September was short lived and that year-over-year inflation had topped 6 percent. It became clear that the high inflation realizations were not as temporary as originally thought. And the October 2021 jobs report showed a significant rebound with 531,000 jobs created and big upward revisions to the previous two months. It was at this point—with a clearer picture of inflation and revised labor market data in hand—that the FOMC took a number of steps to tighten policy. At its December 2021 meeting, the Committee removed the word "transitory" from the statement, accelerated tapering, and signaled the tapering pace would likely evolve in a manner that purchases would end by March 2022.¹² The SEP showed that each individual participant projected liftoff in 2022, with a median projection of three rate hikes in 2022.¹³

The year 2022 was one of historic adjustment in policy. In January, the Committee stated that "with inflation well above 2 percent and a strong labor market, the Committee expects it will soon be appropriate to raise the target range for the federal funds rate."¹⁴ Then, in March, the Committee ended net asset purchases and lifted the target range off the effective lower bound.¹⁵ Over the course of the year, the FOMC raised the target range a total of 425 basis points, from 0.0 to 0.25 percent to 4.25 to 4.5 percent. This path of policy tightening was very different than the one following the Global Financial Crisis (GFC). The latter process, reflecting the economic environment at that time, was much more gradual: tapering of asset purchases took 11 months, the first hike of the policy rate did not occur until more than a year after purchases ended, and the target range was increased in only 25 basis point increments.

The FOMC's actions in 2022 reflected its commitment to bring inflation down at a time when it was quite elevated and while the labor market was very tight. At the time, there was debate amongst economists as to whether policy tightening, especially at a quick pace, could bring down inflation without harming the labor market. What we learned was that the FOMC can move at what seems like an aggressive pace without leading to substantial increases in unemployment.¹⁶ In fact, the Committee's actions hardly budged unemployment and ensured the FOMC's credibility remained intact.

Balance sheet policy was pushed to the background in 2022, and the focus of conducting policy was the setting of the target range. Of course, the FOMC needed to determine how to reduce the size of its substantial asset holdings accumulated from asset purchases during the strains of COVID. In January, the Committee provided a set of Principles for Reducing the Size of the Federal Reserve's Balance Sheet, and in May it announced plans to significantly reduce the size of the Federal Reserve's balance sheet that were consistent with those principles.¹⁷ The May statement outlined the Committee's intention to reduce the Federal Reserve's securities holdings over time in a predictable manner primarily by adjusting the amounts reinvested of principal payments received from securities held in the System Open Market Account.¹⁸ The reduction in the balance sheet started on June 1.

At each meeting from March 2022 to May 2023, the FOMC raised the target range for the federal funds rate. The initial increase was 25 basis points, but subsequent moves were larger, including increasing the target range by 75 basis points at each of the June, July, September, and November 2022 meetings. The swift tightening path reflected the fact that the labor market was very tight, so the Committee could focus on its price-stability goal at a time when inflation was persistently elevated.¹⁹ Acknowledging that alarmingly high inflation is especially painful for lower- and middle-income households that spend a large share of their income on shelter, groceries, gasoline, and other necessities, the Committee moved the target range up toward a restrictive stance as quickly as it judged practical to bolster the public's confidence that the Fed could get inflation down.

In the first half of 2023, with inflation still well above the FOMC's 2 percent objective and with labor market conditions remaining very tight, the FOMC continued to raise the target range for the federal funds rate. However, the FOMC slowed the pace of policy firming relative to late 2022. Factors motivating the slowing included the cumulative tightening of policy in 2021, the additional tightening in credit conditions following the emergence of banking-sector strains in March 2023, and any lags with which monetary policy affects economic activity and inflation. Overall, the FOMC raised the target range 25 basis points at its January, March, and May 2023 meetings, and it held the range steady at its June 2023 meeting. After the June meeting, the target range was set at 5 to 5 1/4 percent.

By mid-2023, in determining the extent of additional policy firming that would be appropriate to return inflation to 2 percent over time, the FOMC planned to "take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments."²⁰ The FOMC indicated that it would "continue to monitor the implications of incoming information for the economic outlook . . . [and] would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee's goals."²¹ The path forward was uncertain. Policymakers faced standard challenges, such as determining the neutral rate of interest that they should steer the economy toward in the longer run, as well as challenges particular to this tightening cycle, such as understanding how supply chain dislocations affect inflation and labor market dynamics.²²

As reported in the September SEP, the median of policymakers' projections for the appropriate level of the federal funds rate at the end of 2023 was 5.6 percent, slightly above the target range of 5 1/4 to 5 1/2 percent at that time. ²³ The policy rate was expected to remain elevated throughout 2024 as indicated by the projected median end of year value of 5.1 percent being quite a bit above the median longer-run value of 2.5 percent. Of course, time and data would direct the FOMC to what additional actions, if any, were needed to continue to move the economy toward the Fed's dual mandate.

With policy now restrictive, we can ask, knowing what we know now, should the FOMC have started removing accommodation differently? To be clear, by asking this question, the intent is not to criticize the decisions of the Committee; rather, it is to assess these policy strategies should central banks be confronted with a similar crisis in the future.

One question to ask is whether the guidance issued was too "constraining"; in other words, did it allow enough flexibility for the FOMC to begin raising the policy rate when it was appropriate to do so? Recall, the Committee had decided that raising the policy rate would not begin until the tapering of asset purchases had finished. But to finish, tapering must start—for a given pace of tapering, the longer it takes to start tapering, the longer it will be before the policy rate can be raised. Of course, one can keep the liftoff date fixed and simply taper at a much faster rate, including the possibility of a hard stop of asset purchases. But concerns about financial market functioning, including the ability of markets to absorb the purchases the Fed stops making, typically limit the speed of tapering, particularly given the amount of asset purchases we were making at the time ($120 billion per month).

Given the tapering criteria and subsequent data, the FOMC ultimately had to pivot hard to accelerate the tapering pace. In fact, unlike the normalization timeline after the financial crisis, the Committee completed the tapering of purchases just a few days before it lifted off. If, however, it had less restrictive tapering criteria and had started tapering sooner, the Committee could have had more flexibility on when to begin raising rates. So one might argue that requiring substantial further progress toward maximum employment to even begin the process of tightening policy locked the Committee into holding the policy rate at the zero lower bound longer than was optimal.²⁴

A possible takeaway is that a less restrictive tapering criteria would have allowed more flexibility to taper "sooner and gradually," as opposed to the relatively "later and faster" approach that occurred. Experience has shown that markets need time to adjust to a shift from accommodation to tightening, which was surely a factor in how FOMC statements framed the criteria for key policy actions during the recovery from the GFC and the pandemic. So when issuing such criteria, one should be careful to use language that allows the Committee the flexibility it needs to respond to changing economic and financial conditions.

Now let's turn to the liftoff criteria: "labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time." This criteria was also quite restrictive, and one might argue that it required the economy to be in a situation where our dual mandate had been achieved. Was this the correct criteria? For example, in December 2012, the FOMC, following closely from the Evans rule, pledged that the target range would remain at the effective lower bound "at least as long as the unemployment rate remains above 6 1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored."²⁵ This criteria was considered very dovish policy guidance at a time when the economy was in a slow, grinding recovery. Had the Committee instead adopted this Evans rule in late 2020, the liftoff criteria would have been met in the spring of 2021. This alternative language gives some idea of how restrictive the 2020 guidance was for liftoff, which, recall, was not implemented until March 2022. A lesson is that perhaps more flexibility should be considered in future liftoff criteria.

On top of the liftoff criteria, there is an implication of the expected path of tightening once rates began to rise. For example, most Taylor rules at the end of 2021 suggested the policy rate should be well above zero and close to its neutral value. Consequently, if the rules that use the current state of the economy are specifying that policy should be at neutral and actual policy is at zero, then the policy rate needs to rise quickly. So it should not have been a surprise that the policy rate rose fast in 2022. Rate hikes needed to be larger and more frequent than the 2015–18 tightening pace to get back to neutral. Looking back, should the Committee have signaled a steeper rate path once the liftoff criteria had been met? Perhaps another lesson is that giving forward guidance about liftoff should also include forward guidance about the possible path of the policy rate after liftoff.

Overall, the FOMC's response to tightening after the COVID pandemic was not textbook. It involved much faster tightening of policy than had been seen in more than 30 years. From this experience it should not be a surprise that when looking back, there are lessons to be learned. But policymakers' actions have coincided with stable financial markets, a strong labor market, and inflation moving down from its peak.

Key policy actions in response to post-COVID high inflation