As Inflation Soars, the Fed Needs to Keep Its Head


So much for transitory. U.S. prices rose by 7% in 2021, the highest gain for nearly 40 years. Remember: The Federal Reserve’s target for inflation is 2%, a fact that gets less attention than it used to, back when “hawks” and “doves” were measuring deviations in tenths of a percentage point. It’s an enormous overshoot, and some of it is likely to prove persistent without corrective action.

The good news is that the Fed can no longer be accused of playing down the risks. In the past two months, its policy stance has moved briskly from patience to concern, with a hint of alarm. Chair Jerome Powell told lawmakers this week that he regarded inflation as a “severe threat.” So far, to its credit, the central bank has accomplished this abrupt shift in messaging without roiling financial markets. Investors expect the Fed’s bond-buying program to be promptly wound down and have calmly penciled in four increases in interest rates this year, starting in March.

Will this accelerated timetable be enough? It looks about right — but with the pandemic far from contained and new uncertainties surrounding the omicron variant, it’s impossible to be sure. The Fed needs to keep an open mind, and stay ready to tighten or loosen policy as conditions evolve.

The reasons for the surge in prices are plain enough. Unprecedented supply-chain disturbances have throttled output while equally unprecedented fiscal and monetary stimulus turned demand up to max. Looking ahead, fiscal policy is likely to be much less aggressive. (Supposing President Joe Biden’s stalled Build Back Better plan eventually passes, it would likely involve only a modest further stimulus.) And monetary accommodation is slowly being withdrawn. Even bearing in mind that an inflation spike has the effect of loosening monetary policy (by lowering the real rate of interest), the Fed is no longer deliberately spurring demand.

Yet even as the demand side is coming under better control, the supply side is still a black box. The omicron variant is so transmissible that it’s already causing severe new disruptions and wrecking plans for a return to business as usual. On the other hand, after two years of Covid-19, policy makers seem to be rethinking the trade-off between caution in controlling the disease and the economic disruption caused by strict lockdowns. Adding to these uncertainties are looming questions about the medium term and beyond. What kind of permanent changes, if any, will the pandemic make to the way work is organized? And how many pandemic-related exits from the labor force will be reversed once savings, currently buoyed by high asset prices, start to look depleted?

At the moment, the labor market is unambiguously tight. The unemployment rate stands at 3.9% — and, more pertinently, there are clear signs that wages are rising both in response to worker shortages and to offset higher prices. This incipient wage-price spiral, if it continues, threatens to entrench some part of the current inflation surge and make it persistent. Over the coming months, this will be the key indicator for judging whether the Fed’s corrective action is enough.

Amid all the uncertainty, what’s crucial is that the central bank is no longer seen as boxing itself in to a fixed policy. Again, Powell hit the right note on this on Tuesday. He said the central bank would need to be “humble and a bit nimble.” Exactly.


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