Investors as well as central bankers have been lulled into complacency by forty years of controlled inflation coupled with major economic growth. It’s possible that policy makers were hesitant to react when inflation started up with a vengeance about one year ago. But for many months since that time, it appeared that the Federal Reserve Board had been staggered with disbelief that so much inflation could skyrocket up so quickly. Was the Fed’s policy (or lack thereof) during that period a blunder?
Causes of Inflation: Supply chain hang-ups stemming from Covid initially led to short run shortages of certain products. But long-term shortages of other products needed downstream by other manufacturers, such as computer chips for new cars, propelled demand to new levels. Manufacturers with “just in time” materials replenishment agreements with suppliers found stoppages and other inventory shortage issues that interrupted production. Shortages like these put upward price pressure on those products when units became available. The impact of the $1.9 trillion Covid Relief bill provided an excessive amount of stimulus to an economy that was fundamentally sound, but bruised by the lockdown measures needed to curb Coronavirus. There was so much relief, untold numbers of workers would hold off on returning to work to see if a better job might open up, thereby reflecting a labor market that was slow to come around when the lockdowns did begin to lighten up. This created a huge and growing demand for labor that became one of the most potent inflationary forces in the economy. The long-term impact of the massive amount of Quantitative Easing perhaps also was under estimated.
Lack of Imagination: The Fed’s slowness to react could be attributed in part to its own failure of imagination, along with institutional inertia. Some economists, as well as central bankers, seemed to be in denial that inflation was on the loose, calling it “transitory” with the implication that it might flame out by itself once the supply chain logjam cleared up. The most common criticism of the Fed was that they appeared to be attempting to “fight this war the same way as the last one.” Owing to the successful rebound of the economy after the 2007/8 financial crisis, the consensus was that the economy could receive a massive expansion of fiscal and monetary policy with no detrimental increase in inflation.
Institutional Inertia: Management by committee has its own built-in inertia. The Fed was uncertain as to how the markets would react to a halt in Quantitative Easing to the extent that they probably overlooked the need to begin interest rate tightening along with some form of QE tapering by last September at the latest.
Flexible Average Inflation Targeting: A further Fed blunder could be attributable to its “flexible average inflation targeting” monetary policy changes made in August, 2020. This meant that the Fed believed that the economy should run hot above the standard inflation target of 2% to make up for the periods where it was running much lower than 2%. This had a tendency to promote a wait and see attitude that contributed to postponing the tightening cycle until it was clearly certain that inflation had set in.
Politics: Politics at the Federal level may have also been in play. Chairman Jerome Powell was due to be re-upped in January, 2022, which left him as something of a lame duck chairman for several months beginning in September, 2021. There was due diligence surrounding potential replacements for Powell who was appointed and approved under the previous Administration. But wiser heads prevailed, and Powell’s re-appointment was confirmed by the Administration and Senate. Those four months, however, proved pivotal in the rise of inflation with no changes in monetary policy being taken to combat it.
Next Steps: The Fed has by this time corrected the three major problems—failure of imagination, institutional inertia, and a failed shift in monetary policy. But is the cat already out of the bag? Inflation at 8.5% today is arguably just as serious as the 10% inflation of the 1970’s since the method of computing inflation has changed since that time. Assuming the right steps are in place through the end of this year for the fight against inflation, what will happen next year becomes of a paramount importance. Will the monetary tightening cause a recession? Will the Fed dial back the tightening too soon and allow inflation to get back up off the mat? Note that at no time in history has monetary policy been able to bring down inflation from the 8-10% level without cooling down the economy so much that it lands in a recession.
Sources: Hawks Take Flight, The Economist, April 23rd, 2022.