The U.S. central bank must move “expeditiously” to bring too-high inflation to heel, Federal Reserve Chair Jerome Powell said on Monday, and will, if needed, use bigger-than-usual interest rate hikes to do so.
“The labor market is very strong, and inflation is much too high,” Powell told a National Association for Business Economics conference. “There is an obvious need to move expeditiously to return the stance of monetary policy to a more neutral level, and then to move to more restrictive levels if that is what is required to restore price stability.”
In particular, he added, “if we conclude that it is appropriate to move more aggressively by raising the federal funds rate by more than 25 basis points at a meeting or meetings, we will do so.”
Fed policymakers last week raised interest rates for the first time in three years and signaled ongoing rate hikes ahead. Most see the short-term policy rate – pinned for two years near zero – at 1.9% by the end of this year, a pace that could be achieved with quarter-percentage-point increases at each of their next six policy meetings.
By the end of next year, Fed policymakers expect the central bank’s benchmark overnight interest rate to be at 2.8%, bringing borrowing costs to a level where they would actually start biting into growth. Most Fed policymakers see the “neutral” level as somewhere between 2.25% and 2.5%.
Powell repeated on Monday that the Fed’s reductions to its massive balance sheet could start by May, a process that could further tighten financial conditions.
U.S. stocks extended earlier losses after his remarks and traders boosted bets that the Fed will deliver a half-percentage-point rate hike at its policy meeting in May.
“This is not just going to be a near-term tactical phenomenon,” said Kevin Flanagan, head of fixed income strategy at WisdomTree Investments in New York. “This is a more strategic type of messaging, I think, from the Fed.”
A consensus for more aggressive tightening – or at least an openness to it – appears to be growing
Atlanta Fed President Raphael Bostic, who expects a slightly gentler path of rate increases than most of his colleagues, said earlier on Monday he is open to bigger-than-usual rate hikes “if that’s what the data suggests is appropriate.”
Speaking on Friday, Fed Governor Chris Waller said he would favor a series of half-percentage point rate increases to have a quicker impact on inflation.
The U.S. unemployment rate currently is at 3.8% and per-person job vacancies are at a record high, a combination that’s pushing up wages faster than is sustainable.
“There’s excess demand,” Powell said, adding that “in principle” less accommodative monetary policy could reduce pressure in the labor market and help stabilize inflation without pushing up unemployment, generating a “soft landing” rather than a recession.
Inflation by the Fed’s preferred gauge is three times the central bank’s 2% goal, pushed upward by snarled supply chains that have taken longer to fix than most had expected and that could get worse as China responds to new COVID-19 surges with fresh lockdowns.
Adding to the pressure on prices, Russia’s war in Ukraine is pushing up the cost of oil, threatening to move inflation even higher. The United States, now the world’s biggest oil producer, is better able to withstand an oil shock now than in the 1970s, Powell noted.
Although the Fed in normal times would not likely tighten monetary policy to address what in the end may be a temporary spike in commodity prices, Powell said, “the risk is rising that an extended period of high inflation could push longer-term expectations uncomfortably higher.”
Last year, the Fed repeatedly forecast that supply chain pressures would ease and then was repeatedly disappointed.
“As we set policy, we will be looking to actual progress on these issues and not assuming significant near-term supply-side relief,” Powell said on Monday. Policymakers began this year expecting inflation would peak this quarter and cool in the second half of the year.
“That story has already fallen apart,” Powell said. “To the extent it continues to fall apart, my colleagues and I may well reach the conclusion we’ll need to move more quickly and, if so, we’ll do so.”
Fed policymakers hope to rein in inflation without stomping on growth or sending unemployment back up, and their forecasts released last week suggest they see a path for that, with the median view for inflation falling to 2.3% by 2024 but unemployment still at 3.6%.
Powell said he expects inflation to fall to “near 2%” over the next three years, and that while a “soft landing” may not be straightforward, there is plenty of historical precedent.
“The economy is very strong and is well-positioned to handle tighter monetary policy,” he said
The Federal Reserve signaled Wednesday that it will likely raise interest rates in March as part of a monetary policy shift to temper an over-heating economy and soaring inflation.
With inflation far exceeding the central bank’s 2 percent target, the Fed plans to increase the cost of borrowing to slow down economic activity, which will hopefully moderate the price surges across commodities and commercial sectors. Prices are increasing at the fastest pace in almost four decades, with 7 percent annual inflation in December. A supply-chain crisis marked by prolonged shipping delays and production bottlenecks is still ongoing and exacerbating inflationary pressures.
Powell also said that the Fed will start to unload its massive balance sheet by tapering off its large-scale purchases of bonds and other assets, a program which the Fed has sustained for many years and which has injected enormous monetary stimulus into the economy. The Fed currently maintains a portfolio of over $8 trillion worth of U.S. government bonds and mortgage-backed securities (MBS).All Our Opinion in Your Inbox
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He said that inflation “has not gotten better. It has probably gotten a bit worse. . . . To the extent that situation deteriorates further, our policy will have to reflect that,” Reuters reported. “This is going to be a year in which we move steadily away from the very highly accommodative monetary policy we put in place to deal with the economic effects of the pandemic.”
However, Powell still kept a sense of optimism that the inflation so many consumers are feeling at the gas pump and across a diverse range of products will have an expiration date, possibly in the near term. “Like most forecasters we continue to expect inflation to decline over the course of the year,” Powell said Wednesday.
The stock market tumbled in response to Powell’s monetary tightening announcement. Low-interest policies often have the effect of fueling financial market booms, which is why warnings of rate hikes rarely bode well for them.
Policymakers should be cautious about adding more to the national debt and the money supply.
The sharp increase in consumer prices this spring may be a blip but may also be a sign that inflation is returning as a chronic problem. For those of us who can accurately recall the 1970s economy, it is a frightening prospect. Everyone else would benefit from reading contemporaneous news coverage.
Recent events call into question pronouncements of the leading Modern Monetary Theorists who thought that the U.S. could sustain much larger deficits without triggering major hikes in the cost of living. Instead, it appears that the traditional rules of public finance still hold: deficit spending financed by Federal Reserve money creation is inflationary.
Analogies between today’s situation and the 1970s are not quite on target. By the early 70s, inflation was well underway. Instead, we should be drawing lessons from the year 1965, when price inflation began to take off. Prior to that year, inflation seemed to be under control with annual CPI growth ranging from 1.1 percent to 1.5 percent annually between 1960 and 1964 — not unlike the years prior to this one.
Like 2021, the post-election year of 1965 saw the inauguration of an ambitious unified Democratic government. That year, Congress enacted Medicare and Medicaid, began providing federal aid to local school districts, and greatly expanded federal housing programs. At the same time, the Johnson administration was expanding U.S. involvement in Vietnam, increasing the defense budget. The federal budget deficit expanded from $1.6 billion in the 1965 fiscal year (which ended on June 30 in those days) to $27.7 billion, or 3% of GDP, in fiscal 1968.
Although the Federal Reserve made some attempts to ward off inflation, it generally accommodated the government’s fiscal policy according to Allan Meltzer’s detailed history of this period published by the St. Louis Fed. Between calendar years 1965 and 1969, annual CPI growth surged from 1.6 percent to 5.5 percent, setting the stage for the Nixon administration’s closure of the U.S. Treasury’s gold window and imposition of wage and price controls. Inflation reached double digits in 1974 and again between 1979 and 1981. Notably, these were also recession years, refuting the fallacy of the Phillips Curve, which depicted a supposed policy trade-off between inflation and unemployment. By the early 1980s, we had ample evidence that ill-considered policies could give us a combination of high inflation and unemployment, known back then as “stagflation.”
This policy mix was also not great for equity investors. The Dow Jones Industrial Average moved sideways during the inflationary period, closing at the same level in December 1982 as it did in January 1966. One lesson from that period was that high interest rates can be bad for stocks.
That may be one reason the Fed remains reluctant to allow interest rates to rise today. Although messaging from the latest Federal Open Market Committee meeting showed greater willingness to normalize interest rates, action is not expected until 2023.
Rate hikes may bring other worries for the Fed in today’s environment. Given the large volume of variable rate mortgages and corporate loans outstanding in the U.S. today, a rise in interest rates could push highly indebted homeowners and companies into bankruptcy, potentially triggering a recession. The federal government would have to roll over its record stock of short-term debt at higher interest rates, ballooning its interest expense and potentially crowding out more popular spending priorities.
But if private capital is to continue participating in debt capital markets, such as those for corporate bonds and bank loans, interest rates will have to rise to compensate them for the loss of purchasing power on their principal.
Although annual growth in CPI fell sharply after 1982, it is not strictly correct to say that inflation was defeated. Except for a few years around the turn of the century, the federal government continued to run deficits, a portion of which were monetized. Notably, the government began running trillion dollar deficits, and the Fed drove interest rates down to near zero during the Great Recession, but CPI growth remained muted.
But CPI does not tell the whole story. Some sectors of the economy have experienced substantial inflation, but they are not fully incorporated in the consumer price index. Home prices, healthcare costs and college tuition all soared in recent decades. Meanwhile, apparel and consumer electronics remained affordable due to globalization and improved technology.
Back in the 1970s, most of the world was not part of the global economy. Eastern Europe was in the Soviet bloc, while China, Vietnam and India had yet to become major exporters. As more low-cost producers of goods and services came online during the 1980s and 1990s, prices were pushed downward (often and regrettably at the expense of American manufacturing jobs). The trend toward developing countries joining the international trading system and producing inexpensive consumer goods is now over. Indeed, the recent increase in protectionism is, if anything, rolling back the wave of international price competition.
On the other hand, technological improvements may continue to shield us from inflation in certain sectors. For example, the displacement of human cashiers by automated check stands might restrain price hikes at the big box retailers, supermarkets, fast food chains and other establishments that can afford to invest in them. Smaller businesses, facing higher wages, may have to try to pass them through to consumers in the form of higher prices. Already in some parts of the country, restaurants are trying to recoup costs without raising prices on their menus by adding various surcharges ostensibly tied to specific costs.
It is possible that inflation is now moving from assets and human-intensive services to consumer products, but we will need several months of additional data to know for sure. Meanwhile, policymakers should be cautious about adding more to the national debt and the money supply.
“Pretty soon if a man bought a sick horse or a leaky boat, he’d say it ‘wasn’t worth a continental.’ It was a way of describing something as worthless.”
by Thomas Fleming
“Welcome to the Continental Congress.”
“I’m not sure what you mean by that, Mr. President.”
“I mean we’re on our way to a visit to the people who almost lost the American Revolution — if we continue to try to maintain the illusion that our money has any value when the interest rate for borrowing it is zero and we try to solve our mounting debt problems by printing it by the billions.” Continue reading