Three Longs & Three Shorts

Where the Fed went wrong on inflation

Until Lehman Brothers blew up it was fashionable to say that independent central banks are somehow better than central banks which are accountable to the elected government of the day. The dismal performance of financial markets the world over after Lehman went down showed that it really makes no difference whether the central bank is independent or captive to the government; the main challenge is that economists (or anybody else for that matter) can’t foretell the future and usually don’t have the guts to take big countercyclical calls.
With US CPI inflation running at 8%, it increasingly looks like the Federal Reserve’s incompetence in managing the Covid unlock will add another nail in the coffin for independent central bankers. As Sebastian Mallaby, the author of an award winning biography of Alan Greenspan “The Man Who Knew”, says in this piece: “Despite retaining an economics faculty nearly eight times larger than Harvard’s, the Fed has messed up. It is vital to understand where exactly it went wrong — and, therefore, the right lesson for the future.
The initial stimulus was not the error. The pandemic suspended the face-to-face economy; by the second quarter of 2020, real gross domestic product had shrunk by a tenth relative to its peak before the pandemic. Without the Fed’s intervention, the United States would have experienced a depression.”
Instead, the economy expanded. By the second quarter of 2021, real GDP was higher than before the pandemic — a much faster recovery than after the 2008 crisis. By stimulating immediately and in unprecedented size, the Fed performed an extraordinary public service.
Moreover, the initial stimulus posed no problem for prices. In 2020, the Fed’s preferred gauge of inflation, which excludes volatile food and energy, came in at 1.4 percent — below the desired target of about 2 percent. The popularly quoted consumer price index rose even less. By the end of 2020, you could begin to tell a story about how inflation might break out: Consumers were looking to spend stimulus checks; the stalling of globalization removed a brake on prices. But inflation was not the probable scenario.
What came next was one forgivable error, and then a really serious one.”
So what was the ‘forgivable error’? Mallaby says that in the summer of 2021 when core inflation pushed through 6% the Fed mistakenly thought this was a transient surge in prices driven by the semiconductor shortage and by workers delaying their return to work after Covid-19. Given the there really was no prior data with which to model these two supply side shocks, it would be unduly harsh to criticise the Fed for misunderstanding the price surge of summer 2021.
Mallaby then moves to the more serious mistake made by the Fed at the start of 2022: “The less forgivable mistake came at the start of this year. It was not a forecasting error, it was a failure of courage and a triumph of inertia. The Fed acknowledged inflation. But, anxious about upsetting financial markets and reluctant to grapple with the full implications of its error, it refused to rise to the challenge.
At the close of the Fed’s policy meeting in January, Chair Jerome H. Powell described inflation as “elevated.” But he declined to raise the interest rate. At the next meeting, in mid-March, Powell confessed that inflation was “well above” the Fed’s target. Yet still he raised interest rates by only a quarter of a percentage point.
Powell embraced this gradualism, moreover, even though the Ukraine war and the associated sanctions were driving commodity prices skyward. The earlier, forgivable error had been compounded by a huge stroke of bad luck. But rather than scramble to get on top of the problem, the Fed played tortoise.”
Now that inflation is roaring along in America (and pretty much everywhere else) and with the Fed’s credibility smashed, what happens next? Mallaby has an interesting suggestion for the Fed and one the Fed is unlikely to have the courage to implement: “Three decades ago, when the Fed was less committee-driven and more under the sway of an imperial chairman, it was willing to hike rates with less warning and more aggression. In the tightening cycle of 1994, it raised by three-quarters of a percent at a single meeting. Wall Street screamed murder, but Main Street came out fine. Inflation fell, and there was no recession.
Today’s Fed should ponder this. To preserve its credibility as an inflation fighter — and hence its ability to react swiftly to growth shocks — the Fed must react equally swiftly when prices accelerate upward….”