Should the Fed be less complacent about inflation risks?
The recent surge in inflation has led to widespread debate about the policy stance of the Federal Reserve (the Fed). Critics argue that the Fed’s steadfast insistence on maintaining its ultra-accommodative monetary policy even as U.S. economic and inflation outlooks have shifted dramatically in recent months is misguided and indicates a certain degree of complacency regarding ongoing financial and asset market distortions.
Meanwhile, supporters of the Fed’s aggressive stance note that risk of an inflationary overshoot is exaggerated and that it is better to err on the side of doing too much rather than too little. They also note that the current policy approach is in line with the central bank’s new monetary policy framework. Under the revised framework, the Fed’s dual mandate is now centered around making up for shortfalls in employment and working towards an average two-percent inflation target.
Several yet-to-be-resolved questions complicate any near-term assessment of the appropriateness of the Fed’s current policy stance. These include: Are current inflationary pressures mostly transitory and to what extent is the recent spike in price levels related to base-effect distortions? Will supply constraints largely disappear by the end of the year? Will the labor supply increase enough to moderate wage pressures? Will inflation expectations remain well-anchored?
In light of these uncertainties, taking a step back and carefully examining certain fundamental issues may offer some valuable insights. The Fed’s price stability mandate has come to imply a hyper-focus on a narrowly defined measure of consumer price inflation. This is problematic since, even under normal circumstances, various approaches to measuring consumer price inflation are fraught with challenges and pitfalls. Official price indices like the CPI and PCE are burdened by methodological flaws and may not accurately reflect cost-of-living changes experienced by large swathes of society.
Official price indices also fail to account for fluctuations in domestic asset prices. In theory, ignoring volatile asset prices when setting monetary policy may appear reasonable. However, this may be a dangerous oversight when a substantial divergence between asset price inflation and goods and services inflation occurs (as has been the case since 2009). Despite a noticeable shift in the emphasis placed on identifying financial risks in the post-crisis era, financial stability concerns are still not being addressed in a proactive manner by the Federal Reserve.
There is also considerable debate surrounding the incorporation of cost of housing into the most widely used price indices. Recent pandemic-related shifts in consumer spending patterns may have added a further layer of complication in deciphering underlying inflationary trends.
The well-worn adage about warfare – that generals are always preparing to fight the last battle – may also be apt in the current circumstance. Like many military generals, monetary policymakers might be overly influenced by past events and experiences. The post-financial crisis era was characterized by subdued GDP growth rates and lingering concerns about persistently low inflation. Asset prices rose gradually, and the labor market took a decade to fully recover. Some feel that the Fed prematurely tightened policy in 2015 and want to avoid a repeat. Furthermore, during 2019 and early 2020, unemployment rates plunged towards 50-year lows without generating inflationary pressures. This led central bankers to reconsider their basic assumptions regarding the extent of slack in the U.S. economy.
Backward-looking Fed officials might not be fully appreciative of how differently the pandemic shock and its aftermath have played out. Unlike the 2007-09 financial crisis and its aftermath, the speed and scope of both monetary and fiscal policy intervention during the COVID-19 pandemic has been truly astounding. Rapid recovery in asset prices along with a sharp turnaround in the labor market suggest a period of above-trend output growth. There may be far less slack in the U.S. economy as well as the global economy this time around. In fact, aggregate demand has recovered so rapidly that producers are having a tough time maintaining adequate supply.
Can the Fed do something in the near term that neither prematurely curtails the economic recovery nor sets the stage for rising inflation expectations and/or excessive risk-taking? There are, in fact, several modest policy steps that the central bank can take to put the on-going recovery on a more solid footing.
The Fed should soon embark on tapering (and ultimately ending) its asset purchase programs. Given the ongoing real estate boom and the low interest rate environment, it is hard to rationalize monthly central bank purchases of $80 billion of U.S. Treasuries and $40 billion of mortgage-backed securities.
In addition to limiting liquidity injections, the Fed should focus on reducing excessive risk-taking in certain corners of the financial market. In particular, the hands-off approach towards cryptocurrencies may no longer be appropriate. The U.S. central bank also cannot underestimate the longer-term risks posed by the emergence of decentralized finance.
The Fed should also abandon its commitment to maintaining near-zero policy rates until the end of 2023 and be open to an interest rate hike in 2022 if inflationary pressures become entrenched. Persistently high inflation is a slippery slope that may lead to rising inflation expectations, which may necessitate a painful monetary contraction in the future.
The Fed should consider broadening its definition of price stability, given underlying measurement challenges, inflation rates within a range (say, 1.5 percent to 2.5 percent) should be acceptable. Stubborn insistence on attaining a 2 percent average inflation target while disregarding the financial distortions induced by overly accommodative monetary policies may prove to be counterproductive in the long run.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.
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