Fed policy must adjust to inflation


It began to appear occasionally when policymakers were rowing on the ocean of denial. Then more rocks appeared. Finally, they saw that they were heading towards the inflation cliff. Only with great effort can they turn the boat around and row to a safe place.

For someone who started his career as an economist in the 1970s, this is how the world began to feel. Few people would like to believe Milton Friedman’s warning. But he was right. This process began to show up as prices rose in what the late John Hicks called “flexible price” markets (such as food markets). Some price increases can be explained by supply constraints, such as the 1973-74 oil embargo. In what Hicks calls the “fixed price” market, we see excess and shortage of demand. But as price increases become more common, real wages are eroded, and workers become more and more warlike. Finally, the general wage price spiral becomes very obvious.

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What is behind all this? The answer is: being too optimistic about potential supply until it’s too late. Are we making the same mistake now? In my opinion, yes. Even if the price increases we see may be temporary, they may become permanent. In addition, even if someone is more optimistic than this, it seems impossible to justify the current monetary policy environment, especially in the United States. The current policy is meaningful during the depression. But we are no longer at risk of depression.

In May 2020, I noticed the monetarist Tim Congdon (Tim Congdon) warning of impending inflation. In early 2021, well-known Keynesians, especially Lawrence Summers and Olivier Blanchard, joined, mainly in response to the huge amount proposed by Joe Biden Fiscal stimulus plan. I reiterated my concerns about inflation in March and May and other occasions.

The 10-year U.S. Treasury yield (%) line chart shows that inflation expectations are not high, but they have been rising

Now, the worryers feel that they have been proven correct. In a recent column, Summers responded in detail to Fed Chairman Jay Powell’s view of “team transition” put forward by Fed Chairman Jay Powell in Jackson Hole in August. This is not surprising. In the United States, the headline inflation rate reached 6.2% in the year ending October 2021. To make matters worse, the core inflation rate (excluding food and energy prices) reached 4.6%. Fortunately, things look better in the Eurozone and the UK, with core inflation rates of 1.9% and 2.9%, respectively. The European Central Bank’s view that the inflation threat in the euro zone is much smaller than that of the US seems to be correct.

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Today, as Summers pointed out, prices are rising in many areas of the US economy, including housing. In addition, inflation expectations generated by the gap between traditional Treasury bonds and index-linked Treasury bonds have risen by approximately one percentage point in the past year. As Jason Furman of Harvard University emphasized, the labor market is showing signs of stress. Of course, the latter has basically recovered. (See chart.)

Nevertheless, people can still notice special factors. These include soaring natural gas prices. A detailed analysis by the International Energy Agency describes many factors on supply and demand-including “the European underground gas storage level at the end of September was 15% lower than the five-year average.” Therefore, although the intensity of demand plays a role, it is not the only factor.

Energy price line chart, (index, October 5, 2020=100) shows that natural gas, coal and electricity prices have indeed soared this year

A similar point is the nature of the surge in demand after the crisis, especially the boom in the purchase of durable consumer goods. This is probably because many people are nervous about eating out or other services. The surge in demand for durable goods is reflected in the demand for industrial inputs, and it is also reflected in the demand for transportation in the global extended supply chain. In fact, Capital Economics chief economist Neil Schilling asserted that the real situation “is how the supply chain is performing in light of the huge shift in demand to commodities.”

However, as time goes by, special factors become less and less credible, and concerns about inflation will become more entrenched. With fiscal policy now tightening, even in the United States, the burden of macroeconomic stability falls on the central bank, especially the Federal Reserve. However, there is no macroeconomic case that does not implement Biden’s “rebuild better” plan. Furman believes that “in the medium and long term, this will have minimal impact on inflation” and there are many benefits.

Line chart of EU gas storage usage, the average monthly filling level percentage (%) shows that the level of natural gas in European gas storage in 2021 is lower than normal

All large central banks are still largely locked in the policy environment launched in March 2020, which was the peak of the panic caused by the new crown virus. In the United States, this seems very inappropriate.After all, inflation is rising so fast that real short-term interest rates are close to reduce 5%, even at the core inflation rate. It is difficult to understand why this is happening now. The problem today is supply, not demand. The Fed can do nothing about this.

Probably because the Fed has shifted to target average inflation and therefore delayed obvious normalization measures. However, in my opinion, the world’s leading central bank should respond to its past failures by deliberately making the opposite error in the future, which has never made sense, and William Bout also elaborated on this point. This just adds new uncertainties.

The line chart of actual personal consumption expenditure in the United States (February 2020 = 100) shows that durable goods consumption has soared after the Covid crisis

Another reason for the delay may be the belief that the “hot” economic operation will bring huge social benefits and limited costs. This is a good argument for maintaining demand. But if the rapid rise in inflation is not dealt with, this is a risky argument. The danger is that the results may continue to be worse than expected. Then the Fed will be forced to catch up. The cost of doing so will greatly exceed the cost of adjusting its ultra-loose policy now.

I very much hope that this inflation will disappear. But hope is not enough. The current policy settings look inappropriate. The Fed needs a new senior management, ready to stand up and think about the actual situation of the United States and the world economy. Turning to currency sobriety faster now can prevent having to cold turkey in the future.

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