In the present effort to quell inflation, all eyes have turned to the Federal Reserve. Is the central bank up to the task? The Fed’s recent actions and rhetoric would seem to answer in the affirmative, but its behavior over the last year casts a shadow of doubt.
Since the Fed awakened last March to the need for counter-cyclical policies, it has shown a welcome conviction. It has reversed its practice of injecting new money into the system and now sells assets from the hoard it amassed in past years. To discourage the use of credit, a major contributor to inflationary pressure, the Fed has also begun to raise interest rates—so far raising the target rate by 1.5 percentage points, to about 2 percent. Policymakers, led by chairman Jerome Powell, have promised more such moves, and they will be essential. Monetary policy will not effectively combat inflation until interest rates are a good deal higher. At today’s interest rates, a borrower pays about 2 percent a year for the use of the lender’s money yet repays after a year in dollars with 8 percent to 8.5 percent less buying power. Effectively, the lender pays the borrower more than 6 percent interest in real terms. This hardly discourages borrowing.
The Fed was tardy in starting to address this challenge. Instead of acting promptly when inflationary pressures first became apparent in the spring of last year, Powell ignored them, insisting throughout 2021 (along with fiscal policymakers in the Biden administration) that price pressures were “transitory.” Perhaps initially, this dismissive approach had some reason behind it. The economic situation—a recovery from pandemic lockdowns and quarantines—was novel, and supply-chain problems obscured the underlying situation. But at the same time, the Fed surely should have seen, as many warned at the time, that years of near-zero interest rate policies and waves of quantitative easing were financing huge government deficits with new money—a digital version of financing government with the printing press and a classic prescription for inflation. Yet the Fed continued along easy monetary policy lines until March 2022.
This approach was both counterproductive and embarrassing. As inflation rose last year, Powell insisted to Congress and the public that the price pressure would soon abate. Even as 17 of the 24 major subsections of the consumer price index rose at rates far above the Fed’s informal 2 percent inflation target, Powell argued that just a few, supply-constrained areas were pulling the overall inflation indices upward. Treasury Secretary Janet Yellen echoed Powell. President Biden, as late as last fall, claimed that the recent surge was “expected” and would abate. This was suspect even at the time because no such inflation surge appeared in either earlier Fed forecasts or the White House’s own budget. And the White House continues to lay the blame on special conditions, implicitly claiming that inflation is not an underlying problem.
This dithering did not just squander precious time; it undermined public confidence in the insight and will of policymakers. That loss of confidence renders the Fed’s present effort all the more difficult. Now workers, managers, and investors expect inflation and are altering their behavior accordingly. In a classic wage-price spiral, workers make wage demands to compensate for expected increases in the cost of living; managers grant these raises, sure that they can repair any damage to the bottom line by hiking prices. Inflation has begun to take on a life of its own, and as the experience of the last great inflation in the 1970s and 1980s showed, those expectations drive rising prices and make it that much harder to bring them under control.
The Fed needs not only to take counter-inflationary steps but also to erase the inflationary expectations its failures last year helped create. A commitment to do what is necessary has begun to help in this crucial effort. But it would further calm matters if the Fed were to acknowledge publicly the inflationary effect of past policies. Powell could reassure the public in at least two ways if he were to state that it had been inflationary to use new money, as the Fed did in the last few years, to buy some $5 trillion in new government debt. Such a confession would reassure the public that monetary policymakers have no intention of returning to such practices. And by putting politicians on notice that they will have no such financial help in the future, it might offer some hope of a return to the budgetary discipline that has been sorely lacking for years now and that also has contributed to our predicament.
Even under the best of circumstances, the Fed would face a daunting task. But its past decisions make the job harder. Even as the Fed undertakes strenuous anti-inflationary policy measures, it is equally important for the central bank to reassure the American public that it knows what it needs to do and has the will to do it. Powell is beginning to show that he has such determination, but doubts remain.
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