Opinion – Martin Wolf: Fed is too late to get the booze out of the room

On November 22, US President Joe Biden renamed Jay Powell as chairman of the Federal Reserve, the country’s central bank. Eight days later, Powell told Congress that it was “probably a good time to retire that word and try to explain more clearly what we mean.” The magic word he was about to retire was “transient”.

This enchantment had allowed the Fed to maintain an extremely expansionary monetary policy during a strong recovery accompanied by rising inflation. A skeptic might think there was something more than accidental about the timing of retiring the word. I wouldn’t be able to comment. Instead, let’s hope the change isn’t too late.

In 1955, President William McChesney Martin observed that the Fed “is in the position of the aunt who had the punch bowl removed just as the party was heating up.” It was a wise decision, as the monetary turmoil some two decades later demonstrated. Losing control of inflation is politically and economically damaging: restoring control often requires a deep recession. However, the Fed has been taking that risk lately, because it hasn’t even started to pull out the high-alcohol punch bowl yet.

Whether inflation is truly transient is not primarily determined by what happens in specific product markets. It depends more on the environment in which these shocks occur. The risk is that in a highly favorable policy environment such as the current one, a price shock could easily ripple through the economy as workers and other producers struggle to recoup their losses.

Therefore, we must start from the state of the economy. The Institute of International Finance (IFI) notes that real consumption in the United States has now fully returned to its pre-pandemic trend. This did not happen after the 2008 financial crisis. Business and residential investment is also extremely robust. The recovery is stronger than in other large high-income countries. The main reason for this solid health, argues the IFI, was fiscal stimulus.

The labor market has also recovered substantially and, to some extent, is buoyant. In a recent paper for the Peterson Institute for International Economics, Jason Furman and Wilson Powell show that the most productive age non-employment rate, the unemployment rate, the number of unemployed per job, and the dropout rate are all stronger. than the 2001-2018 average. The last two are at record levels. As Jay Powell himself noted at his press conference last week, “Labor market conditions are consistent with full employment in the sense of the highest level of employment compatible with price stability.” In other words, the Fed has already fulfilled its mission on jobs.

The strong labor market is also revealing itself in the rapid rise in nominal incomes, with total compensation for civilian workers above the pre-pandemic trend. However, real compensation was 3.6% below the December 2021 trend. This was because annual consumer price inflation reached 7%, the highest rate in four decades. Even core inflation (which does not include volatile items like energy and food) reached 5.5%. Also, contrary to the belief that this is due to just a few items, the IFI shows that inflation is above 2% on more than 70% of the weighted index. This price increase is not a limited phenomenon.

The rate of price increase for scarcer items will decrease, and many prices will even drop. But that won’t be enough. One reason is that affected companies and workers will seek to recoup their losses, risking an inflationary spiral. Another is that the policy is still aggressively lax, given current asset purchases and a basic Fed funds rate of 0.25%. Whatever the supply disruptions, a central bank still needs to calibrate policies to demand. However, the Fed continues to serve the punch, despite the party turning into an orgy.

Furthermore, given the “long and variable lags” in the relationship between monetary policy, the economy and inflation described by Milton Friedman, it is hard to believe that the Fed is anywhere near where it needs to be today. The Fed itself agrees: the crunch is on its way. But the question is whether it can still contain an inflationary spiral and keep expectations stable without having to inflict a recession. It will be extremely difficult to achieve this. Policymakers simply don’t know enough about the post-pandemic economy to calibrate the policy changes needed, especially since they are clearly overdue.

In this context, the Fed’s December forecasts are baffling. The median view is that core consumer price inflation will decline to 2.7% this year and 2.3% in 2023 as the unemployment rate stabilizes at 3.5%. Meanwhile, the Fed’s base rate is forecast to be between 0.6% and 0.9% this year and 1.4% and 1.9% in 2023 (if we leave out the three highest and lowest three) .
These forecasts are, it should be noted, below the Fed’s own estimate of the neutral interest rate, which is 2.5%. In addition, the assumed real interest rates are also negative. Perhaps board members believe that aggressive asset sales will provide the needed contraction through higher long-term rates.

Alternatively, they have to believe that the economy and inflation will stabilize smoothly, even if monetary policy remains expansionary at all times.

It would be perfect stabilization. It is possible that the policy settings chosen during the worst phase of the Covid crisis still make sense today. It is also conceivable that the predicted contraction will provide for robust growth and smooth disinflation. Both are less unlikely than the moon to be made of green cheese. But likely? Not so much.

Translated by Luiz Roberto M. Gonçalves