Reviews | Where the Fed got inflation wrong

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Two years ago, central bankers seemed omnipotent. In response to the coronavirus shock, the Federal Reserve unleashed a much larger stimulus than that which followed the 2008 financial crisis. The intervention allowed Congress to pursue its own stimulus without worrying about the national debt: the Fed was buying government bonds as fast as the Treasury could issue them. The United States has entered the era of don’t tax, just spend. It was the magic money age.

But now the magic has evaporated. Inflation has reached its highest level since 1980. As a result, the central bank will have to raise interest rates several times this year, possibly triggering a recession. Despite maintaining an economics faculty nearly eight times larger than Harvard’s, the Fed has screwed it all up. Understanding exactly where it went wrong – and therefore the right lesson for the future – is essential.

The initial stimulus was not the error. The pandemic has suspended the face-to-face economy; in the second quarter of 2020, real gross domestic product was down a tenth from its pre-pandemic peak. Without the intervention of the Fed, the United States would have experienced a depression.

Instead, the economy grew. In the second quarter of 2021, real GDP was higher than before the pandemic – a much faster recovery than after the 2008 crisis. By providing stimulus immediately and on an unprecedented scale, the Fed performed an extraordinary public service.

Also, the initial raise was no problem for prices. In 2020, the Fed’s preferred inflation gauge, which excludes volatile food and energy, came in at 1.4%, below the desired target of about 2%. The commonly quoted consumer price index rose even less. By the end of 2020, you could start to tell a story about how inflation might break out: consumers were looking to spend stimulus checks; the stalemate of globalization has lifted a brake on prices. But inflation was not the likely scenario.

What came next was a forgivable mistake, and then a very serious one.

The forgivable mistake began in the summer of 2021. By then, the Trump administration’s stimulus had been amplified by a much larger Biden package; in the second quarter, underlying inflation stood at 6.1%, well above the Fed’s target. But the Fed called the surge “transient.” A shortage of semiconductors was causing a temporary spike in car prices, the central bank argued. Workers’ fear of covid-19 was delaying the return to work and causing temporary bottlenecks.

Looking back, that was too optimistic. The more gloomy forecasters are now entitled to their victory dances. But the error counts as forgivable because the Fed was faced with unprecedented questions: How many citizens would return to work? How quickly would government stimulus be spent? Many respected analysts agreed with the Fed that inflation would prove transitory.

The least forgivable mistake came at the start of this year. It wasn’t a mistake in forecasting, it was a lack of courage and a triumph of inertia. The Fed has acknowledged inflation. But, anxious to disrupt financial markets and reluctant to grasp the full implications of his mistake, he refused to take up the challenge.

At the close of the Fed’s policy meeting in January, Chairman Jerome H. Powell called inflation “high.” But he refused to raise the interest rate. At the next meeting in mid-March, Powell admitted that inflation was “well above” the Fed’s target. Yet he only raised interest rates by a quarter of a percentage point.

Powell embraced this gradualism, even as the war in Ukraine and associated sanctions sent commodity prices skyrocketing. The previous mistake, forgivable, had been compounded by a huge stroke of bad luck. But rather than scrambling to fix the problem, the Fed played the turtle.

While the central bank is edging forward, inflation is racing. Excluding the effects of seasonal variations, consumer prices rose 0.6% in January from the previous month. In March, the inflation rate doubled to 1.2%. Unsurprisingly, the Fed’s credibility has taken a beating: More Americans care about inflation than crime or immigration, according to a CBS News poll. And it’s not like the Fed has to move incrementally to protect workers. The labor market, in Powell’s words, is “extremely tight.”

Three decades ago, when the Fed was less committee-driven and more in the grip of an imperial chairman, it was willing to raise rates with less warning and more aggressiveness. In the 1994 tightening round, it rose three-quarters of a percent at a single meeting. Wall Street cried bloody murder, but Main Street got away with it. Inflation fell and there was no recession.

Today’s Fed should think about it. To preserve its credibility as an inflation fighter – and therefore its ability to react quickly to growth shocks – the Fed must react just as quickly when prices accelerate higher. Sometimes there’s nothing wrong with upsetting Wall Street, and sometimes the best course of action is the monetary equivalent of a handbrake turn. Once upon a time, the Fed knew it.

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