Central banks are supposed to inspire confidence in the economy by keeping inflation low and stable. The U.S. Federal Reserve has suffered a frightening loss of control. In March, consumer prices were 8.5% higher than a year earlier, the biggest annual rise since 1981. In Washington, inflation monitoring is usually the province of a few experts working in ramshackle offices. Now, nearly one-fifth of Americans say inflation is the country’s most important problem; President Joe Biden has tapped oil from strategic reserves to try to rein in gasoline prices; and Democrats are looking for villains to blame, from greedy businessmen to Vladimir Putin.
The point is that the Fed had the tools to stop inflation and failed to use them in time. The result is the worst overheating of a large, wealthy economy in the three decades of inflation-targeting central banks. The good news is that inflation may have finally peaked. However, the Fed’s 2% target will still be a long way off, forcing the central bank to make painful decisions. Supporters of U.S. policymakers point to annual price increases of 7.5% in the euro area and 7% in Britain as evidence that this is a global problem caused by rising commodity prices, especially since the Russian invasion of Ukraine. Nearly three-quarters of eurozone inflation is attributable to soaring energy and food prices.
Now, the United States benefits from an abundance of shale gas, and its higher incomes mean that commodities have less of an effect on average prices. Excluding energy and food, Eurozone inflation is 3%; however, U.S. inflation is 6.5%. Moreover, the U.S. labor market, unlike in Europe, is clearly overheating, with wages growing at an average rate of almost 6%. Recent falls in oil, used car and shipping prices are likely to mean that inflation will come down in the coming months. Still, it will remain too high, given the underlying upward pressure on prices.
Economic stimulus during the pandemic amounted to 25% of GDP.
Uncle Sam has been on a unique trajectory due to Biden’s $1.9 trillion excessive fiscal stimulus, which was passed in March 2021. That measure added an additional boost to an economy that was already recovering rapidly after multiple rounds of spending and brought the total pandemic stimulus to 25% of GDP, the highest in the rich world. When the White House stepped on the accelerator, the Fed should have applied the brakes. It didn’t. Its hesitancy was due in part to the difficulty of forecasting the trajectory of the economy during the pandemic and, also, to the tendency of policymakers to follow the strategies of the past. For most of the decade following the 2007-2009 global financial crisis, the economy was collapsing and monetary policy was too restrictive. Predicting the return of inflation was the province of those wearing tinfoil hats.
However, the Fed’s failure also reflects an insidious shift among central bankers around the world. Many, everywhere, are dissatisfied with the formal job of managing the business cycle and want to take on tasks with more charm, from fighting climate change to minting digital currencies. At the Fed, that shift was evident in promises that it would pursue a “broad-based and inclusive” recovery. Such a rhetorical shift overlooked the fact, taught to any student of economics, that the unemployment rate at which inflation soars is not something central banks can control.
In September 2020, the Fed codified its new views by promising that it would not raise interest rates until employment had reached its maximum sustainable level. The pledge guaranteed that it would stay well behind the curve. It was cheered by left-wing activists eager to instill an egalitarian spirit in one of Washington’s few functional institutions.
The result has been a mess that only now is the Federal Reserve trying to clear up. In December it forecast a paltry 0.75 percentage point interest rate hike for this year. Today, a 2.5-point increase is expected. Both policymakers and financial markets believe this will be sufficient to control inflation. Again, they are likely to be overly optimistic. The usual way to contain inflation is to raise rates above their neutral level (believed to be around 2-3%), rather than the rise in core inflation. That points to a fed funds rate of 5-6%, unheard of since 2007.
Such high rates could slow the rise in prices, but at the cost of creating a slowdown. In the last 60 years, the Fed has only three times managed to significantly slow the US economy without triggering a recession. And never having let inflation rise as high as it is today.
A U.S. contraction therefore looms over the global economy as part of a triad of risks, along with Europe’s energy security and China’s struggle to eradicate covid-19. Poor and middle-income countries, above all, have much to lose from a sharp rise in interest rates by the Federal Reserve that would drive capital away and weaken their exchange rates; especially if a global slowdown at the same time reduces demand for their exports.
Many economists advocate higher inflation
Does the Fed have the guts to inflict such economic pain? Many economists advocate higher inflation, because in the long run interest rates would rise in tandem and thus move away from zero, a level below which they are difficult to cut in a crisis. Inflation is already helping the federal government by reducing the real value of its debts. Around 2025, when the Fed reviews its policymaking framework, it will have the opportunity to raise the target. There is nothing special about 2% other than the fact that the Fed has promised it in the past.
Stable inflation slightly above 2% might be tolerable for the real economy, but there is no guarantee that the Fed’s current stance will be able to deliver even that. And breaking promises has consequences. It hurts long-term bondholders, including foreign central banks and governments holding $4 trillion in Treasury bonds. (A decade of 4% rather than 2% inflation would at the end of that period cut the purchasing power of the money repaid by 18%.) It could add an inflation risk premium to the cost of U.S. borrowing. And furthermore, if even the U.S. breaks its inflation promises in hard times, investors may fear that other central banks (many of which look down their noses at indebted governments) will do the same. In the 1980s, recessions triggered by Paul Volcker’s Fed laid the groundwork for inflation targeting regimes around the world. Every month that inflation soars, some of that hard-won credibility vanishes.
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Translation: Juan Gabriel López Guix