History will not judge Jerome Powell’s Federal Reserve kindly for its many policy mistakes, especially if those mistakes lead to a boom-bust cycle of inflationary growth followed by a nasty economic recession next year.
Among the most basic mistakes that the Federal Reserve is making is to ignore Milton Friedman’s fundamental teaching that monetary policy operates with long and variable lags. A corollary of this teaching is that if the Fed waits for actual signs of inflation to emerge before it starts to tighten monetary policy, it will have waited too long to avoid inflation expectations from becoming entrenched. By so doing, it will have set the stage for a nasty economic recession next year to wring inflation out of the economy.
This makes it all the more difficult to understand the Fed’s reluctance to begin tapering its aggressive bond-buying program or thinking about an early interest rate hike. Why is the Fed waiting, with the economy already booming, with the economy now receiving the largest peacetime budget stimulus on record and with an enormous amount of pent-up demand built up during the COVID-19-induced lockdown now waiting to be released as the economy returns to some semblance of pre-COVID normality? Those factors constitute a potent cocktail that will likely lead the economy to overheat by yearend.
Another classic policy mistake that the Powell Fed is making is to allow monetary policy conditions to loosen at a time that the economy is getting a record boost from the budget and from COVID-related pent-up demand. The Fed is allowing that loosening by keeping interest rates unchanged at a time that inflation is rising and by encouraging the equity and housing market to continue to boom with its aggressive bond-buying program.
By keeping interest rates unchanged at a time that the Fed itself has boosted its 2021 inflation forecast from 1.8 percent at the start of the year to 3.4 percent at present, the Fed is allowing inflation-adjusted interest rates to become meaningfully negative. That encourages both households and firms to borrow and spend. Similarly, the Fed is boosting demand by its bond-buying actions that have the effect of increasing equity and housing wealth. The Fed’s own economic models suggest that as household wealth increases so does its spending. That’s the last thing one needs at a time that the economy risks overheating.
Another dangerous policy mistake that the Fed is making is to add to the present equity and housing market bubbles by still buying $120 billion a month in U.S. Treasury bonds and Mortgage-Backed Securities. This has already led to a situation where U.S. equity valuations are now more than twice their long-term average and at a lofty level seen only once before in the past 100 years. It has also led to a situation in which today’s U.S. housing prices adjusted for inflation are above their 2006 level on the eve of the U.S. housing market bust.
In combination, these policy mistakes bode ill for next year’s U.S. economic outlook. By choosing to delay monetary policy action now to nip inflation in the bud, the Fed is inviting economic overheating by yearend and the consequent un-anchoring of inflationary expectations. At the same time, by continuing to add to the equity and housing market bubbles, the Fed is setting us up for another painful equity and housing market bust when the Fed is eventually forced to slam on the monetary policy brakes to fulfill its inflation mandate.
The Fed faces difficult policy choices. But by its decision not to change policy at a time of growing signs of consumer price and asset price inflation, the Fed heightens the risk that we will experience another painful boom-bust cycle next year.
Desmond Lachman is a senior 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.