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With inflation soaring and the Federal Reserve dithering, waiting for its run of securities purchases to end, there is a maelstrom of controversy and Wall Street one-upmanship about how many interest-rate increases can dance on the head of a pin … I mean, how many will be executed in 2022, of course.
There is nothing scientific about this. It’s all about opinion, forecasting and the Fed’s stance of risk-aversion.
The question is whether the Fed has any options capable of delivering steady, on-target inflation and full employment without a recessionary misstep. There are many options; there may not be any good ones. And it’s a mid-term election year.
Policy sweet spot
The Fed’s ability to raise rates just enough to damp and return inflation to path (2%) without creating a recession is a tall order for a central bank with such crude policy tools — basically, rate hikes, balance sheet policy and perhaps forward guidance.
The Fed may have frittered away its chance to achieve a “soft landing” (the euphemism for slowing the economy while keeping growth in a positive trajectory with inflation controlled) by delaying action.
Meanwhile, inflation measured by the consumer price index cooks at higher than 7% with a target at 2% (according to the personal consumption expenditures, the Fed’s preferred measure). The Fed’s odd policy pledge to not raise rates until inflation ran at or above 2% for some time and until the economy reached full employment is another culprit in the Fed’s rate-hiking reluctance. That pledge was probably the worst policy framework a central bank ever adopted.
Still, the Fed was caught out by the rapid rise of inflation, which it first denied but now it fears. Denial has cost the Fed time. And time is critical. Like when treating disease, if it runs too long without treatment, it can become too entrenched for medicine to work effectively. There may no longer be a sweet spot.
Is a soft landing out of reach?
Seven percent inflation is severe. But we do not know how long such a pace will persevere. If the Fed is right about at least some of it being transitory and if inflation does ease “on its own” in 2022, the Fed might find it can control it without an excessive move in rates. But nobody knows. It’s guesswork, and the Fed needs to put itself in a position to control events regardless whatever happens.
If inflation is stuck and stubborn at 7%, we are going to have a recession. If a small amount of inflation rolls off, we will probably have a recession. But if CPI inflation can run to 3% to 3.5% maybe as high as 4% by year-end, the Fed may not be like a dog chasing a car it cannot catch.
That’s why I prefer for the Fed to stick to a moderate regime of rate hikes and to give the future a chance to reveal itself. If the Fed is too aggressive early, that could destabilize and worry markets since they will project future Fed action before we know what is going to be needed — and they will do that by evaluating the Fed’s early moves. But if the Fed is measured, and gets lucky, it may not have to hike rates so much. In that case, a soft landing might still be possible. But if supply problems linger, if a wage-price/(price-wage) spiral kicks in, the Fed will be forced to take a more extreme policy response that will threaten the economy more severely.
If there were a referee for inflation, he would be throwing the penalty flag. There definitely is “piling on” with price markups coming without being pushed by cost pressures. Since prices are rising, there is cover for companies to raise prices and a lot of it is being done without cause — but not without effect.
Inflation is most dangerous when it comes and stays and spreads. If it spikes to 7% and drops quickly, it will not be as damaging. The Fed’s job is to make sure that that happens, not to sit back, do nothing and hope that happens. The Fed needs to move — better sooner than later.
Robert Brusca is chief economist of FAO Economics. He worked at the Federal Reserve Bank of New York from 1977 to 1982, including a stint as chief of the International Financial Markets Division.
