Fed Complacency Feeds Inflation; WSJ

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Inflation is a bigger challenge than the Federal Reserve acknowledges. It has already risen dramatically, and it is suppressing real wages. Expectations of further inflation have begun to influence wage demands, costs of production, supply-chain estimates, and business pricing strategies. Lower-income earners are being squeezed the most.

It isn’t enough that the Fed says it will begin tapering its asset purchases, while it continues to hope that inflation will recede to 2% when supply shortages dissipate. The Fed must acknowledge that its monetary policy has been a source of inflation, and that it will need to raise interest rates more quickly than it presumed.

The Fed’s new strategic framework prioritizes maximum inclusive employment, emphasizing full employment for all groups of people, while favoring temporary inflation moderately above its longer-run 2% target. But while allowing the economy to overheat, the Fed has also emphasized the importance of keeping inflationary expectations anchored close to 2%.

Things haven’t worked out as the Fed intended. Inflation has run far above the Fed’s forecasts, well before its employment objective has been reached. Labor markets are showing stresses, and rising expectations of inflation now threaten to reinforce the trends of higher wages and inflation and harm economic performance.

It is ironic that high inflation, combined with the Fed’s zero rates and asset purchases, benefits the better off and harms lower-income earners—the people the Fed’s strategy intended to help. Prices of housing, food and energy, three of the highest-cost items for lower-income earners, are accelerating sharply. Energy and food prices are beyond the Fed’s control, but housing costs are directly linked to monetary policy. Lower-income earners tend to be renters, who face sharply higher rental costs, while higher-income households tend to be homeowners, who benefit from soaring home values. Zillow’s rental-cost index has risen 12.8% in the past year, and the S&P CoreLogic Case-Shiller home-price index is up 19.9%.

To be sure, supply shortages and distribution bottlenecks have contributed to higher inflation, and labor shortages have pushed up wages. But the higher inflation wouldn’t have occurred without a strong recovery in demand. They had their pandemic collapse in the second quarter of 2020, and their recovery from that was the fastest rise in history. The Fed attributes that recovery to pent-up demand, while it understates the role that monetary policy plays in the economy. Unprecedented deficit spending has joined the Fed’s interest rates and massive asset purchases to fuel the boom in aggregate demand.

Some of the inflation pressures will ease as supply shortages dissipate, but if demand remains strong, generated by continuing monetary and fiscal stimulus, then inflation will remain elevated. Even when the Fed tapers its asset purchases, it will reinvest maturing assets to maintain financial liquidity and keep interest rates anchored to zero. This will fuel cheap debt financing for consumers and businesses. Meanwhile, fiscal stimulus continues to flow. The Government Accountability Office reported in July that $1 trillion of the deficit spending authorized by pandemic-related fiscal legislation has yet to be spent. Congress is considering new infrastructure and social legislation that would pump even more money into the economy.

Rising expectations of inflation have been compounded by the Fed’s shortsighted playing down of the role monetary policy plays in generating demand. Market-based expectations of inflation over the next five years have risen to 2.9%, while survey-based measures put expectations closer to 4%.

Wage negotiations are reflecting a catchup to the sharp rise in inflation and are incorporating the expectation of persistent inflation, and in those negotiations, workers have the upper hand. In August there were 10.4 million job openings and 6.2 million new hires. The gap represents nearly the entire shortfall of current employment from pre-pandemic levels. Employment will rise to close the gap, and wages will accelerate. Businesses are basing their pricing decisions on expectations of persistently elevated inflation.

This is exactly what the Fed didn’t want to happen. The Fed needs to quell these reinforcing expectations. The central bank appropriately imposed emergency monetary policies in response to the collapse in economic activity and jobs in the spring of 2020. But even as the recovery proceeded far faster than expectations, the Fed has presumed dulled responses and subdued inflation similar to what occurred following the 2008 financial crisis. The Fed lacks systematic guidelines for conducting monetary policy. Common sense suggests that the Fed should be normalizing interest rates.

Mr. Levy is senior economist at Berenberg Capital Markets and a member of the Shadow Open Market Committee.

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Appeared in the November 1, 2021, print edition.

Source: https://www.wsj.com/articles/fed-complacency-feeds-inflation-unemployment-supply-asset-11635705390?mod=hp_opin_pos_2#cxrecs_s

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