The Fed has finally responded to growing inflationary pressures. It has, at least preliminarily, begun selling bonds to drain liquidity from financial markets and, with it, some of the inflationary fuel in the system. This latest effort is especially welcome, because until now, Washington had all but ignored the growing evidence of inflation, characterizing it as “transitory.” If inflation persists, as now seems likely, monetary policy will have to shift much more, but this first step is a good beginning and will do no harm if it really turns out to be brief.
Inflation figures offer ample justification for a policy response. The Labor Department’s consumer price index has risen at a 6 percent annual rate so far this year. That compares to 0.2 percent in 2020 and an average of 1.5 percent per year in the five years before that (2015–2019). Producer prices have risen at well above a 10 percent annual rate this year, compared with 0.5 percent last year and an average rate of close to zero for the prior five years. All other price measures have followed a similar pattern, including the prices of metals and other critical industrial materials. Food prices are rising so fast that supermarket chains are stocking up to get ahead of the next price hike.
Both economic theory and history also give us plenty of reasons to worry. The Fed has been pumping liquidity into financial markets for more than a decade now, starting with the 2008 financial crisis. Back then, the Fed had little choice but to push interest rates down to zero and redouble the monetary easing by directly entering markets to buy bonds—what the central bank calls “quantitative easing.” Without this help, markets would have collapsed and dragged the whole economy down with them. Normally, the Fed would have unwound these policies after the crisis had passed, but the recovery unfolded so slowly that policymakers kept the extreme stimulus going. The Fed began tentative efforts to moderate the extent of monetary easing in 2014 but proceeded only gradually. That ended in 2019, when policy again became easy, ostensibly to alleviate the strains of the “trade war” with China. The pandemic in 2020 brought a return to zero interest rates and still greater injections of liquidity into markets.
Despite all this history, neither Fed chairman Jerome Powell nor the Biden administration seems ready to take inflation seriously. Powell insists that the recent inflation spike is largely a statistical artifact of temporary supply interruptions caused by the pandemic, and Treasury Secretary Janet Yellen has echoed Powell. Even President Joe Biden has gotten into the act, saying that he trusts his “experts” who, he assures us, “expected” the inflation to happen and expect it to dissipate soon. One might wonder what the president means, since this year’s inflation spike appeared in neither last year’s economic projections from the White House Budget Office nor in Fed forecasts.
The current anti-inflationary policy actions effectively fly in the face of such dismissive statements. The Fed, to be sure, has resisted radical action, which is wise at this early stage of response. Policymakers have left interest rates low, no doubt because a rise in rates would have called attention to their inflation concerns and could have caused panic in financial markets. The Fed has instead begun to sell some of the bonds it bought in earlier waves of quantitative easing. (Technically, it has initiated “reverse repurchase agreements.”) These sales, in classic anti-inflationary fashion, have drawn liquidity out of financial markets. The move has already had an effect on the money supply—the key link, both historically and theoretically, to inflation. The broad M2 measure of money, which had been growing at 25 percent on an annualized basis, slowed during spring and early summer to a rate of about 8.5 percent. Two regional Fed presidents have made statements reinforcing this policy adjustment: Mary Daly of the San Francisco Fed and Robert Kaplan of the Dallas Fed have each indicated that bond purchases will begin to taper off before the end of the year.
Much more will be needed if inflation persists. The Fed would have to unwind a significant part of the tsunami of liquidity it has poured into financial markets off and on for the last 13 years. Credit constraints and rising interest rates will be an inevitable part of the picture. The effort may require even more extreme measures than were used in the last great anti-inflation fight, in the 1980s, largely because the Fed muddled policy with its 2008 decision to begin paying interest on deposits that banks hold in reserve with it.
That 2008 decision was especially unfortunate. Before it, banks kept the minimum required by law on deposit at the Fed. As a result, any extra liquidity injected into the system was lent out promptly and affected the economy almost as fast, and when the Fed reabsorbed liquidity, banks pulled back lending just as quickly. But now that banks earn on their reserve deposits, those deposits have grown and have at times blunted the effect of liquidity injections on the economy. They have also created a cushion against any future liquidity withdrawals. At present, more than 90 percent of the reserves held by banks at the Fed are in excess of the amounts required by law. If the banks were to draw on this excess for lending, they could easily confound any efforts to combat inflation by removing liquidity from the system, forcing the Fed to take even more extreme measures.
Against such prospects, perhaps it’s understandable that Powell and the Biden administration would rather not take the inflation news seriously. A more sober response would require them to explain how policy might change to cope—and that would force them to describe the difficult situation that the Fed faces and to explain how these difficulties are at least partly of the Fed’s own making. As embarrassing as that might be, a little transparency from Washington’s “experts” might help, especially if a policy change becomes necessary. Still, we should hope that Powell and the administration turn out to be right that the current inflation spike is transitory. As anyone who lived through the 1970s and 1980s knows, anti-inflation monetary policies are not pleasant, and the economic pains and distortions associated with them even less so.
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