Asleep at the wheel at the Fed

Asleep at the wheel at the Fed
© Washington Post/Pool

John Maynard Keynes famously said, “When the facts change, I change my mind. What do you do, sir?”

Evidently the Federal Reserve led by Chairman Jerome Powell does not seem to subscribe to Keynes’s view about how one should adapt one’s thinking to material new information. Even though the U.S. economic and financial market facts are changing in a major way, the Fed remains doggedly committed to its zero-interest rate policy and to its expansive bond buying program. Past experience with inflationary episodes and with the bursting of asset price bubbles strongly suggest that the Powell Fed’s policy approach will not have a happy ending.

A clear indication of the Fed not adapting to changing facts was its non-reaction to the January 2021 Georgia Senate run-off election that paved the way for the $1.9 trillion America Rescue Plan. 

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Unfazed by the new fact that the U.S. would be embarking on its largest peacetime budget stimulus on record, amounting to some 12 percent of GDP in 2021, at the same time that a successful vaccination program would be releasing a large amount of pent-up household demand, the Fed made little change to its inflation forecast. Worse yet, the Fed saw no need to contemplate interest rate hikes before 2024 or to stop buying $120 billion a month in U.S. Treasury bonds and mortgage-backed securities for the foreseeable future. 

A more recent example of the Fed’s failure to materially adapt its views to changing economic facts was yesterday’s very tepid response to growing indications that the country might have an inflation and a labor shortage problem. Even though over the past three months the Personal Consumption Expenditure Deflator, the Fed’s favored inflation yardstick, has been increasing at an annualized rate of around 7.5 percent, the Fed has stuck to its view that the inflation problem that we are now experiencing is but a transitory phenomenon.

Similarly, even though job openings and unfilled vacancies keep rising to new all-time highs, the Fed assures us that the economy will not overheat despite the massive budget and monetary policy stimulus that it is now receiving.

To be sure, the Fed has now upwardly revised its 2021 inflation forecast to 3.4 percent, which is well above its 2 percent inflation target. However, it still contemplates that there will be no need to increase interest rates till 2023 at the earliest. 

An even more surprising example of how the Fed does not change its views in the light of changing facts relates to the emerging bubbles in the U.S. housing, equity and credit markets. It does not seem to bother the Fed that U.S. house prices today, adjusted for inflation, are at their 2006 peak and are increasing by 12 percent a year. Nor does it seem to faze the Fed that equity valuations are now at around as much as twice their long-run average or at a level that has been experienced only once before in the last 100 years.

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Instead, the Fed keeps on feeding these bubbles with the maintenance of ultra-low interest rates and with its large bond buying programs. In particular, seeming to have learned nothing from the 2008 U.S. housing and credit market bust, the Fed continues to buy $40 billion a month in mortgage-backed securities and only grudgingly concedes that it is now beginning to consider a start to tapering its massive bond-buying program.

It is said that those who cannot remember the past are doomed to repeat it. This would seem likely to prove particularly true of the Powell Fed. By keeping interest rates at ultra-low levels at a time of record peacetime budget stimulus, the Powell Fed seems to be repeating Fed inflationary mistakes of the 1970s, when monetary policy was kept too loose at another time of budget irresponsibility. By keeping interest rates too low for too long and by excessively expanding its balance sheet, the Fed seems to be repeating its past mistakes of inflating housing and equity market bubbles with very easy monetary policy.

All of this is very likely setting us up for a hard economic landing next year. When in an overheated economy the Fed belatedly will be forced to slam on the monetary policy brakes to fulfill its inflation mandate, we must expect that today’s housing and equity market bubbles will burst. If past experience is any guide, they will do so with devastating consequences for the economy.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.