Edward Price, a former British economic official and current lecturer in political economy at New York University’s Center for Global Affairs, looks at the dangerous path ahead for a Federal Reserve trying to defuse the US economy without hitting markets let collapse.
Not so long ago, the Fed was worried. Why could it not produce inflation at a meager 2 percent?
Indeed, in the summer of 2020, the world’s most important central bank was so concerned that it unveiled a framework aimed at stimulating price pressures and encouraging job creation. The centerpiece was the flexible average inflation target, or FAIT. FAIT will give officials the leeway to keep the economy warm, with inflation rising beyond its 2 per cent target for an unspecified but limited period. The US labor market will therefore become tighter. All this while the Fed’s inflation-fighting credentials have remained firmly intact.
The theory was that the past decade has shown that the US economy can tolerate much higher employment rates without the risk of a downward spiral in wages and prices. So, as the pandemic closed businesses and jobs were lost, the Fed did the obvious thing. It started a search for inflation that consisted of interest rate cuts and unprecedented injections of liquidity into financial markets.
Now inflation is here. During the first half of 2021, Fed officials promised it would be temporary. But October’s Consumer Price Index (CPI) came in at 6.2 percent. This inflation, it turns out, is tough and much higher than the Fed might want. And so it’s changing course. After indicating earlier in the pandemic that tariffs would will remain discontinued until the end of 2023, minutes of the Federal Open Market Committee’s December vote published last week indicates that it is considering hikes during the first half of this year.
All this means that the US Federal Reserve is taking a turn. But what kind of maneuver will bury price pressure?
What everyone wants to see is a U-turn, a smooth and controlled change of bearing. In this scenario, the Fed will roll up to the lights, signal carefully and then swing its hood seamlessly around. Everyone will be happy. The FOMC will say it has given a lot of notice, starting with the December minutes. Investors can adjust their portfolios in an orderly manner. The punchbowl will go. But no one’s booze will spill.
Doubtful. The minutes have already caused a sell-out in technology stocks. Real rate hikes will certainly scare markets, addicted to a small federal fund rate and abundant liquidity as they are.
So, the Fed is in a pinch. Three fortunes beckon. If it gets lucky, inflation is transient and prices are stabilizing at 2 percent. If this is unfortunate, inflation is hedged at levels well above 2 percent. And if it is very unfortunate, prices fall and this revolution becomes an epic mistake. Quite the bind. What happens, however, depends somewhat on what the Fed will do. Small rate hikes to fight non-provisional inflation could dampen that inflation, leading to transient inflation. At what point will the rationale for FAIT look reasonable again. But it’s too tight, and too uncertain, for a big U-turn.
So, we might see a K-turn, a clumsy three-point maneuver. There will be a stop and there will be a start. Things will not be smooth. Wheels will tremble. And all the drinks will rinse. Some investors will be caught out, but we will avoid a major panic.
Unfortunately, there is a problem here as well. A misty windshield. The US’s expansionary fiscal policy will have unknown consequences. And who knows what supply chains will do in 2022? Some expect the hooks to stay on throughout the year. Others expect pressure to ease. Either way, the FOMC will have to act aggressively to offset the impact of stubborn bottlenecks. In addition, many investors ignore the fact that rates at levels are much lower than the previous time when inflation dragged around 5 percent. The extent and pace of reductions priced by markets may therefore be too meager to combat truly stubborn price pressures. Here’s the point. If the Fed can not see the future, and really can not help but walk, it could very well lose control over how far and fast these hikes should go.
Which brings us to a third option: a quick J-turn. This kind of maneuver is rare. Usually keeping the army, it spins the vehicle sharply in reverse. The result is skull-shaking force. Yes, it’s fast. Yes, it is effective. But for passengers, it’s not fun. Everyone’s drinks will spill. And of course we are those passengers.
Tackling inflation like this would raise deep questions about the viability of FAIT. Indeed, it would throw a question mark over the 2 percent targets that have been the hallmark of central banking frameworks everywhere for decades. The concepts behind independent central banking seem far from robust. Indeed, they look rather bad.
And a J-turn would also be quite scary. The hobgoblin of financial crises lies ahead. Central banks cannot reconcile reconciliation to serve the needs of the economy, with ongoing accommodation, for greater financial stability. Super low rates risk financial bubbles and eventual turmoil. But super-high rates run the risk of popping those bubbles in disastrous ways. After years of quantitative easing, the contradiction between the monetary needs of the economy and the monetary needs of markets is inevitable.
All in all, the rise in US prices has revealed the flaw inherent in the open-ended FAIT. Now the Fed will have a hard time driving out of Inflationsville without experiencing an accident. Retiring from years of residence will create conditions that require new accommodation. Normalization will be anything but.
Seat belts please. And make sure you stick to those drinks.