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Last year, when inflation rose, the Federal Reserve not only did not expect it — it denied its existence.
Denial gave way eventually to recognition, but recognition led to procrastination, and eventually that gave way to action.
That’s not textbook monetary policy, by any means. But all that was policy, and it left the Fed in an adverse position it finds itself in today.
Making monetary policy is a razor’s-edge business — small problems can easily mushroom into large ones. And that statement is the brief description of what the Fed did wrong. Fighting inflation is a bit like fighting cancer. The weapons are crude and must be used early. Failure to act early can make all the difference in the success, or failure, of the treatment.
Now the Fed faces its second unexpected event. Gross domestic product (GDP) fell in the first quarter, the government announced last week. Everyone has been talking about how strong the economy is and how it can absorb Fed rate hikes, and then suddenly GDP declines.
Consumer spending is still on its same pre-Covid pace, so it is not the U.S. consumer giving out (at least not yet). The problem is constrained U.S. output as we just saw in the weakening April ISM report — a survey of U.S. manufacturing. The ISM headline has been weaker than its April reading 68% of the time — that’s not too bad. But production has been weaker only 32% of the time, and orders have been weaker only 37% of the time, and those are not good benchmarks.
The problems are: 1. Weakening demand for U.S. exports, and 2. U.S. demand is being satisfied from production overseas; that means U.S. spending stimulus is diverted from the U.S. to those overseas markets. And 3. As a minor factor, inventory building slowed in the first quarter, taking some lift from GDP.
Don’t dismiss GDP decline
Do not ignore the unexpected! We have some economists looking at the drop in GDP as a signal and others wanting to set it aside as a sort of one-off event of little consequence. I think the lesson learned is to not ignore unexpected events.
No one forecasts well enough to dismiss unexpected developments in favor of a forecast. The Fed did this from 2016 to 2018, ignoring the persistent inflation undershoot. It was wrong, and the Fed had to cut rates sharply in mid-2019 to avoid adverse economic developments. It tried to ignore rising inflation in 2021 — how is that going?
Global food-price shock
Moreover, incoming news is worsening. Some of the news from Ukraine should have the Fed recalibrating its outlook on when supply lines will be made whole. The war in Ukraine is dragging out. The Russians are stealing Ukrainian wheat and agricultural equipment.
More devastating to the world is the loss to global agriculture of fertilizers whose price has gone sky-high. Many producers look for smaller crop yields ahead and that means ever-higher food prices. So much for ambitions to corral U.S. inflation quickly or let it fall on its own.
China’s quandary and dilemma
Adding to this perfect storm of unruly events is China’s continued fixation on eliminating Covid, and that it has reverted to a strategy of lockdowns again, further impacting any businesses operating (or trying to operate) in China. China is also navigating a treacherous geopolitical strait as it stands behind Russia but tries to endorse world peace while blaming the West for starting the war that Russia clearly ignited. China is trying not to have Western sanctions imposed on it for helping Russia; so far its “help” has been mostly rhetorical. But China is out on a limb.
Where did inflation come from?
To solve the inflation problem, policymakers need to know what caused it. To do that, please park all partisan baggage at the door. Economists are now nearly universally in agreement that fiscal policy overdid it during Covid and in recovery. Larry Summers made that argument in real time.
Some look-back analysis is trying to quote Fed Chair Jerome Powell (presumably, as a neutral figure) as having said that it was better to do too much than too little. He did say that. But Powell was in a political vice that is probably also part of the problem.
Powell wanted to be reappointed and, although Janet Yellen (Treasury secretary under Biden and former Fed chair) was his advocate, many progressives were not for him. We will never be able to prove this but, from my standpoint, Powell’s delay in using monetary policy was a direct result of his not wanting to upset the apple cart on the way to his nomination. I mean him no disrespect with this analysis, but I think it is true.
So the Fed delayed its policy move because of politics, the fiscal stimulus was excessive (even if some of it was bipartisan) at the same time Fed asset purchases cranked up, and that helped to bloat money supply growth. Although bank credit and consumer debt growth were not greatly stimulated by these events, they both did move up. Since fiscal and monetary policy kicked into gear at the same time, we have no hope of statistically disentangling the real culprit for inflation or even of assigning shares of blame. But we have some clear policy mistakes as well as supply chain issues as root causes.
In the recent April ISM report for manufacturing, it is clear that apart from fiscal and monetary mismanagement, U.S. output is slowing, and orders (demand) are slowing. And, yet, Keynesian demand pressures are building. When supply is insufficient, businesses show stress. In the ISM report, I point to supplier delivery speeds getting slower on the month and to the price index in the ISM remaining high along with order backlogs. Even as demand has weakened, production has not been able to make progress in reducing these metrics of stress.
Fiscal policy needs to be more constrained than stimulative despite the president’s wishes to spend more on his domestic pet projects. Yet, the budget will undoubtedly continue to be “busted” to help supply Ukraine with needed armaments.
Prognosis: Recession likely
Recession is likely because the Fed does not know what to do. By this time, the Fed may no longer have a workable policy option. This is not surprising because the Fed has never been able to stop recessions after inflation has risen.
Oh, we see recessions coming ahead of time but not with enough warning to act. Sort of like the Titanic seeing the iceberg but … too late. The Fed has models, lots of ideas, a boat load of economists, but probably no longer the right options.
Inflation is too high, interest rates are too low, the yield curve is simply too flat. There is no way to tweak all these variables to put the economy on a pro-growth, anti-inflation path. The Fed will have to choose one path or the other. The ratcheting up in rates required to stop inflation would sink the economy, while nursing growth would encourage inflation to worsen. The Fed is simply trapped; markets are finally acting as though they can see it.
Lessons learned
So what did we learn? We learned that politics make bad policy, whether it’s fiscal policy or monetary policy. But we were already supposed to know that, weren’t we? Partisanship should never trump well-established policy guidelines.
The Fed needs to stick to known and working economic protocols. Modern monetary theory cannot be used as an excuse to run a social experiment on a real economy in a time of stress.
Moreover, the Fed’s current policy framework statement needs to be changed as of yesterday to demonstrate that the Fed is not going to make the same mistake again of assuming it can drive unemployment lower without consequence. We need to close the book on that and put it back in the “fiction” section.
Both Republicans and Democrats tried to muscle the Fed. Ironically, Trump’s call for an easier Fed policy was right when he made it (despite Trump being heavily derided for it), but the Democrats’ push to stay the Fed’s hand in raising rates was wrong and has fed the inflation beast we now face.
Still, we can’t expect politicians to stop acting like politicians. That’s a risk the Fed simply must manage better than it has. Maybe after the recession it will be able to do that.
Robert Brusca is chief economist of FAO Economics.
