A bold policy response is needed to restore the Fed’s inflation credibility
The writer is president of Queens’ College, Cambridge and an advisor to Allianz and Gramercy.
To suggest that the US Federal Reserve should stop lagging behind inflationary developments on the ground is the polite way of describing what the world’s most powerful central bank needs to do when its policy committee meets this week.
More bluntly, the Fed must immediately halt its asset purchase program, guide the markets to three interest rate hikes and possibly more this year, and bring forward the announcement of plans to reduce its balance sheet to March. He must also explain how he managed to get his call for inflation wrong and why he is slow to react correctly.
Without it, he will struggle to regain political discourse and restore his credibility.
Since the last meeting of the Federal Open Market Committee, on December 14 and 15, the general consumer price index in the United States has crossed the 7% mark. The basic measure of price growth has risen above 5% as drivers broaden. Unemployment fell below 4% while labor force participation remained unchanged, stuck below pre-pandemic levels.
Additionally, the Fed’s estimate for its preferred measure of inflation – the core personal consumption expenditure index – for 2021 is 4.4%, more than double what it had forecast there. a year ago, and the forecast for 2022 has been raised to 2.7%. Further upward revisions in 2022 are surely on the cards.
All of these data points speak directly to the Fed’s mandate. They suggest that monetary policy should no longer be accommodative. Yet it’s still hugely empowering and set to stay that way for some time to come.
Rather than stepping on the brake, the Fed still has its foot on the accelerator: real interest rates after taking inflation into account are extremely negative. While it is about to halt its quantitative easing stimulus program at the end of this quarter, it continues to inject funds into a market stuffed with liquidity.
It’s no wonder that financial conditions have remained historically easy despite a sea change in analysts’ policy decisions since Fed Chairman Jay Powell belatedly ‘retired’ the ‘transitional’ characterization of late inflation. November.
Forward-looking inflationary pressures continue to be fueled not only by producer price increases that have yet to pass through the system, but also by persistent labor shortages, further supply-side disruptions and another 10% rise in oil prices in January.
Having grossly mischaracterized inflation for most of 2021 and missing one policy window after another, the Fed’s persistent and late policy response risks what Powell himself warned was a “serious threat” to livelihoods. As a result, at its meeting this week, it is expected to send a clear message that it is serious about tackling inflationary pressures.
This should be done via an immediate end to QE, forward guidance on three interest rate hikes and signaling that the balance of risk has tilted towards tighter policies. The Fed should schedule the announcement of its “quantitative tightening” plan in March.
To make all of this believable, officials also need to make it clear why they’ve misinterpreted inflation so badly for so long (as stated before, I think this will go down in history as one of the worst calls for inflation ever). central bank), and explain how they are now better able to incorporate a broader set of bottom-up indicators into its macroeconomic modeling and forecasting.
That’s what I think the Fed should do. I fear, however, that this is not the case.
Marked by the experience of three years ago when market volatility forced it to turn around (i.e. return to more accommodative monetary policy even though the economy did not justify it not), the Fed may well favor a more gradual approach.
Indeed, there is a window for such an approach to allow for an orderly policy adjustment that avoids some combination of prolonged high inflation, slowing economic growth, and troubling financial volatility. But this window is very small and very risky.
Judged in terms of risk scenarios, the threat to society is that of a still sluggish Fed that will be forced later this year into an even bigger set of restrictive monetary measures. The result would otherwise be avoidable damage to livelihoods, greater financial instability, higher risk of national stagflation, and greater threat to global economic and financial well-being.
The Fed has an opportunity this week to catch up with the realities on the ground and regain some of its lost credibility. To do this, you will have to be bold. Continuing on its current trajectory risks another much more disruptive policy mistake later this year.