/ world today news/ The US Federal Reserve turned to the cent, something uncharacteristic of an institution long known for slow and deliberate changes in monetary policy. While the Fed’s recent announcements (they haven’t done anything yet) haven’t been as creative as I’d hoped, they’ve at least acknowledged that there’s a serious problem.
That problem, of course, is inflation. Like the Fed where I worked in the early 1970s under Arthur Burns, today’s policymakers have re-diagnosed the original epidemic. The current rise in inflation is not a transitory phenomenon, nor can it be dismissed as the product of idiosyncratic events related to COVID-19.
This growth has been widespread, sustained and reinforced by wage pressures stemming from an unprecedented tightening of the US labor market. Under these circumstances, the Fed’s continued refusal to change course would be an epic policy blunder.
But acknowledging the problem is only the first step to solving it. And solving it will not be easy.
Consider the math: The inflation rate, as measured by the consumer price index, reached 7 percent in December 2021. With the nominal federal funds rate /effectively zero/, this translates into the real funds rate (the preferred measure of the effectiveness of monetary policy) from minus seven / – 7/ percent.
This is a record low.
Only twice before in modern history, in early 1975 and again in the mid-1980s, did the Fed allow real funds to fall to -5 percent. These two events led to the Great Inflation, when, over a period of more than five years, it rose at an average annual rate of 8.6%.
Of course, no one thinks we’re in for a sequel. I’ve been worried about inflation for a long time, longer than most, but even I don’t accept that possibility. Most forecasters expect inflation to fall this year. As supply chain bottlenecks gradually ease and markets become more balanced, this is a reasonable presumption.
But only to a certain extent. The forward-looking Fed still faces a critical tactical question: What federal funds rate should it target to meet the most likely rate of inflation 12-18 months from now?
No one has a clue, including the Fed and the financial markets.
But one thing is certain. With the real federal funds rate at minus 7 percent, putting the Fed in a deep hole, even a rapid slowdown in inflation does not preclude aggressive monetary tightening to reposition the real funds rate so that it is well aligned with the Fed’s monetary stability mandate ..
To figure this out, the Fed must hazard a guess as to when the inflation rate will peak and begin to decline to a lower level. It’s always hard to guess the date－and even harder to figure out what “lower” actually means. But the US economy is still hot, and the labor market, at least as measured by falling unemployment, is tighter than at any time since January 1970 (on the brink of the Great Inflation).
In these circumstances, I would argue that a responsible policymaker would prefer to err on the side of caution and not bet on a quick, miraculous reversal of inflation back to its sub-2 percent pre-COVID-19 trend.
Again, consider the math: Let’s say the Fed’s projected policy, as represented by its latest “dot plot,” is correct and the central bank takes the nominal federal funds rate from zero to about 1 percent by the end of 2022 year. with a reasonable estimate of the trajectory of disinflation – not too slow, not too fast – which projects year-end CPI inflation to move back into the 3-4 percent zone. That would still leave the real federal funds rate in negative territory of -2% to -3% later this year.
That’s the catch in all of this. In the current easing cycle, the Fed pushed the real federal funds rate below zero for the first time in November 2019. This means that a likely -2% to -3% rate in December 2022 would mean a 38-month emergency period monetary adjustment, during which the real federal funds rate averaged minus 3.1 percent.
Historical perspective is important here. There were three earlier periods of extreme monetary accommodation worth noting: After the dot-com bubble a generation ago, the Fed under Alan Greenspan ran a negative real funds rate of 1.1% on average for 31 consecutive months. After the global financial crisis of 2008, Ben Bernanke and Janet Yellen teamed up to maintain an average real funds rate of -1.9% for a full 62 months. And then, as the post-crisis sluggishness continued, Yellen partnered with Jerome Powell for 37 straight months to hold the real funds rate at -0.9 percent.
Today’s Fed is playing with fire. The real federal funds rate of -3.1% is now more than twice the -1.4% average of those three earlier periods. Yet today’s inflation problem is much more serious, with CPI growth likely to average 5 percent from March 2021 to December 2022, compared to the 2.1 percent average that prevailed in earlier negative interest rate regimes on real funds.
All of this underscores the fact that perhaps the riskiest policy the Fed has ever pursued is now underway. He injected record stimulus into the economy during a period when inflation was running at more than twice the rate of his three previous experiments with negative real funds rates. I intentionally left out the fourth comparison: the -1.7% real federal funds rate under Burns in the early 1970s. We know how that ended. And I also omitted any mention of the equally aggressive expansion of the Fed’s balance sheet.
It is now meaningless to warn that the Fed is “behind the curve”. In fact, the Fed is so far behind it can’t even see the curve. Its dot charts, not only for this year but also for 2023 and 2024, do not match the degree of monetary tightening that will most likely be needed as the Fed struggles to bring inflation back under control. Meanwhile, financial markets are in for a very rude awakening.
The author, a professor at Yale University and former chairman of Morgan Stanley Asia, is the author of the book: Unbalanced: The Copendency of America and China.
Translation: ES
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