Fed policy must adjust to inflation


It starts with the occasional pebbles as policymakers row on the sea of ​​denial. Then many more rocks appear. Finally, they see that they are sailing towards an inflationary cliff. It is only with a lot of effort that they turn around and paddle to safety.

This is how the world begins to feel for someone whose life as an economist began in the 1970s. Few people wanted to believe Milton Friedman’s warnings. But he was right. The process began to be visible with price increases in what the late John Hicks called “flexprice” markets, such as food. Some price increases could be explained by supply restrictions, such as the 1973-74 oil embargo. In what Hicks called “fixed price” markets, we saw excess demand and shortages. But, as price hikes became more widespread and real wages eroded, workers became more and more militant. Finally, a general wage-price spiral has become all too visible.

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What is behind all this? The answer is: over-optimism about the potential supply, until it’s too late. Are we making the same mistakes now? In my opinion, yes. Even though the price increases we are seeing could be transitory, they risk becoming permanent. Moreover, even if one is more optimistic than that, it seems impossible to justify the current framework of monetary policy, especially in the United States. Current policy would make sense in a depression. But we no longer risk depression.

In May 2020, I noted warnings from monetarist Tim Congdon about inflation to come. In early 2021, well-known Keynesians including Lawrence Summers and Olivier Blanchard joined us, largely in response to the huge fiscal stimulus offered by Joe Biden. I reiterated my concerns about inflation in March and May and on other occasions.

Line graph of 10-year US Treasury yield (%) showing inflation expectations are not high, but they have risen

Now the worried feel justified. In a recent column, Summers provides a detailed response to the “transitional team” perspective put forward by Federal Reserve Chairman Jay Powell at Jackson Hole in August. It’s not surprising. In the United States, headline inflation reached 6.2% through October 2021. Worse, core inflation (excluding food and energy prices) reached 4.6%. Fortunately, the position looks better in the Eurozone and the UK, with core inflation rates of 1.9% and 2.9%, respectively. The opinion of the European Central Bank that the inflationary threat is much lower in the euro area than in the United States seems correct.

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Today, as Summers notes, prices are rising in many sectors of the US economy, including housing. In addition, inflation expectations stemming from the spread between conventional and index-linked Treasury bills have risen by around one percentage point over the past year. As Harvard’s Jason Furman points out, signs of pressure are appearing in labor markets. Admittedly, the latter have largely recovered. (See graphics.)

Nevertheless, one can still note particular factors. Among them, soaring gas prices. A detailed analysis by the International Energy Agency describes a number of factors on the demand and supply side, among which “underground gas storage levels in Europe at the end of September were 15% lower at their five-year average levels “. So, while the strength of demand played a role, it was not the only factor.

Line graph of energy prices (indices, October 5, 2020 = 100) showing that gas, coal and electricity prices have indeed skyrocketed this year

A similar point is the nature of the surge in demand after the crisis, in particular the rush to purchase durable consumer goods. This is probably because a lot of people are nervous about going out for a meal or other service. The sharp increase in the demand for durable goods is manifested in the demand for industrial inputs and therefore also for transport through the extensive supply chains of the world. Indeed, Neil Shearing, chief economist at Capital Economics, says the real story “is how far the supply chain has resisted given the huge shift from demand to goods.”

Yet, as time passes, the special factors become less credible and fear that inflation may take further root. With fiscal policy tightening, even in the United States, the burden of macroeconomic stabilization falls on central banks and in particular the Fed. There is, however, no macroeconomic case that cannot be done with Biden’s “Build Back Better” program. This, Furman argues, “would have minimal impact on inflation in the medium to long term” and would also do a lot of good.

Line graph of gas storage usage in the EU, monthly average fill level percentage (%) showing gas levels in European storage were below normal in 2021

All the major central banks are still largely locked into policy parameters introduced in March 2020, at the height of the Covid-induced panic. In the United States, this seems extremely inappropriate. After all, with inflation rising so rapidly, real short-term interest rates are close to less 5 percent, even on the core inflation rate. It’s hard to see why this should be the case now. Today’s problems are related to supply, not demand. There is nothing the Fed can do about it.

The Fed may be holding back the obvious moves towards normalization due to its shift towards an average inflation target. Yet it never made sense to me for the world’s largest central bank to react to its past failures by deliberately making opposite mistakes in the future, a point also touched upon in detail by Willem Buiter. This only adds new elements of uncertainty.

Line graph of real personal consumption expenditure of the United States (February 2020 = 100) showing consumption of durable goods skyrocketed after the Covid crisis

Another reason to wait may be the belief that running the economy ‘on the go’ will bring significant social benefits and limited costs. This is a good argument to support demand. But it’s a risky argument for not responding to rapid increases in inflation. The danger is that the results will continue to be much worse than expected. The Fed would then be forced to catch up. The costs of that would far exceed those of adjusting his ultra-loose politics now.

I very much hope that this inflation will disappear. But hope is not enough. The current policy settings appear inappropriate. The Fed needs a new direction ready to step back and reflect on the real situation of the US and global economies. A faster move towards monetary sobriety now could avoid having to go cold turkey later.

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