What if the Fed Is Wrong?
With inflation roaring how much longer for free money?
Inflation only matters when it matters — but when it does, nothing else counts.
After Wednesday’s eyepopping report of a 6.2% annual rise in prices in October (highest since 1990), President Joe Biden said, “reversing this trend is a top priority for me.” So far, there is no sign that the Federal Reserve Board agrees.
The Fed continues to say that rate increases are many months or even a year away. Its argument is that inflation is caused by transitory supply-chain issues, which will eventually moderate.
But the Fed did not anticipate the supply-chain problem, did not anticipate the inflation that resulted from it, did not (once inflation emerged) anticipate how acute or persistent the problem would become.
Rather than assume that the Fed’s crystal ball has improved, is it time for the Fed to react to facts on the ground? That might mean a significant hike in the federal funds rate — which has been stuck on close to zero since the pandemic — now.
I spoke with economists of varying opinions on this. Most admitted to a degree of uncertainty — one nice thing about economists (journalists, take note) is that most have developed a sense of humility.
And most still back the Fed. Mark Zandi, the chief economist of Moody’s Analytics, rejected the suggestion of a one-point rate hike with the observation that, even given last month’s booster shot of a half-million new jobs, the U.S. remains four million jobs shy of the pre-pandemic peak. A sharp rate hike would jolt markets, even “shock” them, Zandi said. But he did allow that the Fed probably should “pull expectations for future rate hikes forward.”
Julia Coronado, President of MacroPolicy Perspectives, sloughed off the comparison to the 1970s, when inflation rose to double digits (a period that left my generation traumatized). She noted that, unlike in the salad days of Jimmy Carter, the U.S. dollar now is not under pressure from foreign currencies.
When you step back, Coronado says, the Fed’s policy has been “very effective, more effective than expected in powering a very strong US recovery.” For an economist, this is the equivalent of saying, “Zowie! Jobs are up, output, investment, profits are up —what’s not to like?”
She admits that, given how strong the economy is, it might seem bizarre to be lending overnight money for … nothing. But, like Zandi, she favors transitioning to higher rates “methodically,” the better to protect global stability as well as the U.S. labor market.
Coronado also acknowledges that the labor market has been tighter, and demand stronger, than expected. And therefore, inflation has been “stickier.” Although she expects absent workers to return, relieving pressure on wages, “There is some risk that the labor market remains tight and a self-reinforcing dynamic between wages and prices develops.” She hasn’t seen it yet, and she is confident that were this to occur, the Fed would quash it.
The argument on the other side is simply that every day that banks lend overnight money at zero percent, it adds to the inflationary fires. Lending at zero when inflation is 6% is an invitation to borrow, because the debt can be repaid with depreciating dollars. Borrowing is how money is created. Just so, in the last year, M2, a measure of the money supply, has risen 13%. This is a source of classic monetary inflation, as distinct from the supply-chain driven variety.
To the extent that inflation is supply-chain driven, there is no sign of the supply chain becoming unsnarled. Meanwhile, inflation seems to be working its way beyond strictly pandemic-related industries.
The annual increase in October was 20% for beef and veal, 12-13% for furniture, 12% for eggs, 10% for new cars and trucks, 9% for women’s dresses, 8% for boys and girls footwear and 50% for gasoline. Rent is rising, too. As Michelle Meyer, head of U.S. economics at Bank of America, told the New York Times, “What’s striking is the broadening of the inflationary pressures.”
Rather than, as expected, moderate, inflation in October accelerated. In that one month, restaurant prices jumped 5.3%.
Measures of inflationary expectations are also rising. As firms raise wages to lure back workers, there are signs of a wage-and-price feedback loop. The Wall Street Journal quoted Jim Bullard, President of the St Louis Fed, saying he is worried that an “inflationary process” has started. Admitting there is a case for thinking that the inflation will dissipate, he added, “You can only put so much probability on that scenario.”
Bullard’s nod to probability reminds us that forecasts are inescapably uncertain. What troubles me about the current policy is that the risks seem weighted to one side.
If the labor market is flourishing at a 0% interest rate, it will also do fine at 1%. Indeed, that would still be five percentage points below the inflation rate, which the textbooks would describe as radically stimulative.
On the other hand, if the Fed is spiking a generalized inflation, it will want to reverse course before the potential ‘self-reinforcing dynamic’ Coronado alluded to gathers steam.
And the hankering for a steady, “methodical” policy shift likely assumes an omniscience that is beyond mortal policymakers. Perhaps the Fed will be able engineer a quiet landing in 2022 or ’23 — but perhaps, by then, other events — now unforeseeable — will alter the script, as has happened so often before. One possibility: the bond market, so far comatose, will decide it doesn’t like inflation. Then all bets for stability are off. In that event, the earlier the medicine is administered the easier it goes down.
I talked to one other economist — Greg Mankiw, chairman of the Council of Economic Advisers under George W. Bush. Mankiw said, “The Fed is struggling with the question of whether the high inflation rate is only a transitory supply-chain problem or a more fundamental overheating of the economy. So far, they have leaned toward the former hypothesis. But various indicators, such as the large number of job openings, suggest that the economy is running quite hot right now.
“Of course, employment is still well below the pre-pandemic peak. But the pandemic may have changed things, such as inducing earlier retirement for some people,” rendering the former peak irrelevant.
“Putting everything together,” Mankiw sums up, “The Fed should — and likely will — tighten sooner than they previously anticipated.
“I worry that they might move too slowly, as any rapid change in policy would in effect admit that their previous thinking was mistaken. And the Fed, like everyone else, hates admitting error.”
The irony is that easy monetary policy is starting to hurt workers, one group that the policy is designed to help. Inflation is more than offsetting wage gains. Since January, real wages are down 2.2%.
This is uncomfortable for Biden, to say the least. No incumbent wants to face a midterm election when gas, grocery, and other prices are soaring. And Biden has yet to announce whether he will reappoint Jay Powell as Fed chairman. Among likely candidates, Powell remains the best. The question is whether Powell will return the favor, to Biden and to the country, and arrest the inflation before it gets out of hand.