Prices are rising at the highest rates in 40 years. The Federal Reserve’s overly expansionary policy is the main culprit. Yet the Fed has taken only minimal actions to address this issue.
After more than a year of inaction, the Federal Open Market Committee (FOMC) finally started raising interest rates. It increased its federal funds rate target by 25 basis points in March, 50 basis points in May, 75 basis points in June, and another 75 in July.
However, these rate increases were too late and too small to stem the current wave of inflation. The FOMC will need more drastic actions to get inflation down and signal to the public that it is taking inflation seriously. They should also seize this opportunity to implement long-term policy reforms.
Consumer price inflation
Over the past year, the consumer price index (CPI) has risen by 9.1 percent, while the personal consumption expenditures price index (PCEPI) is up 6.3 percent. Americans face ever rising prices for regular living expenses like food, gas, housing, and clothing.
Fed officials have come to accept monetary policy as a major cause of recent high inflation. Auto computer chip and raw material shortages played a role in the early stages of recovery and high oil prices have contributed more recently. However, price increases have been widespread. Core PCEPI inflation, which excludes food and energy prices, is far above the Fed’s long-term target of two percent.
The inflation problem appears to be persistent, not “transitory” as Fed officials had previously claimed. Despite the recent rate hikes, inflation remains elevated. The FOMC projects inflation will be above target through 2024. Financial markets’ implied expectations of future inflation have declined over the last month, but still suggest inflation will exceed 2.5 percent per year over the next five years.
The Fed’s inaction
The widespread and persistent price increases appear to be a symptom of monetary policy. Why didn’t the Fed respond sooner to the threat of inflation?
First, Fed officials relied too strongly on their technical models, which predicted that inflation was transitory. They failed to learn from their mistakes in the Great Recession of 2007-2009, when overreliance on faulty models prevented the FOMC from cutting interest rates fast enough, which amplified the magnitude of the recession.
Second, the FOMC adapted the interpretation of its mandate in ways that allowed more inflation. It changed from an inflation target of two percent per year to an average inflation target of two percent over time (so they claimed), which delayed its response to high inflation. It reinterpreted its full employment mandate to be more inclusive and promised not to raise interest rates until the economy reached this expanded conception of maximum employment. In addition, Fed officials prioritized nonmonetary goals like inequality, climate policies, and emergency lending to nonfinancial companies, diverting its attention from the core task of keeping inflation low.
Third, the Fed monetized the fiscal deficit on an unprecedented scale. On its own, debt-financed government spending has little effect on total spending. The additional government spending enabled by newly issued bonds tends crowd out private sector spending, as businesses and consumers face higher interest rates. When the Fed monetizes those bonds, however, the new money boosts total spending and, with it, prices.
In response to the pandemic, Congress increased fiscal spending by $5 trillion. The Fed purchased around $3.4 trillion in U.S. Treasury bonds. In other words, the Fed monetized roughly 68 percent of the debt required to finance the fiscal policy response.
What can be done?
In the short run, the Fed must address the inflation problem. Increasing interest rates may not be enough. The Fed should adopt a monetary policy rule in order to increase their credibility and minimize uncertainty about their policies. As Scott Sumner and others have argued, a nominal spending rule might be the most effective way to achieve neutral, predictable monetary policy.
In the long run, the Fed should get back to basics. Fed officials must prioritize monetary stability over political objectives such as inequality and climate policy. To simplify its operations, the Fed should consider returning to the pre-2008 corridor system of monetary policy.
Thomas L. Hogan is senior research faculty at the American Institute for Economic Research. He was formerly the chief economist for the U.S. Senate Committee on Banking, Housing, and Urban Affairs.
READER COMMENTS
vince
Jul 29 2022 at 5:02pm
As of 7/29/22, the PCE index for the past year is up 6.8%, with core CPE 4.8%. The annualized rates for June are 12.7% and 7.4%. Hopefully the June and July rate increases will start showing effects.
Today the 5 year breakeven inflation is about 2.6%, almost exactly where it was a year ago, when inflation was said to be transitory. Hmmm …
I don’t understand why the stock market–up about 5% the last two days–isn’t concerned about inflation. It’s responded as if the soft landing has arrived and we’re on our way out of any downturn.
You’re too easy on Congress and Executive branches. What would they have done if the Fed soaked up the $5 trillion in fiscal spending? They’re motives are so clear. They want to hand out candy, for votes, and then skewer the Fed if it responds prudently.
What has Congress and Executive branches done to resolve supply shortages and lack of productivity? They’re pushing all the responsibility to the Fed.
Spencer Bradley Hall
Jul 30 2022 at 8:47am
As I said: The only tool, credit control device, at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be properly controlled is legal reserves. The FED will obviously, sometime in the future, lose control of the money stock.
May 8, 2020. 10:38 AMLink
Powell eliminated legal reserves in March 2020. But Powell didn’t raise capital requirements like the other Central Banks who manage their banks without reserve requirements.
Daniel L. Thornton, May 12, 2022 agrees with me:
“However, on March 26, 2020, the Board of Governors reduced the reserve requirement on checkable deposits to zero. This action ended the Fed’s ability to control M1. In February 2021 the Board redefined M1 so that M1 and M2 are very nearly identical. Consequently, it makes little sense to distinguish between them. In any event, the checkable deposit portion of M2 cannot be controlled now because there are no longer reserve requirements on these deposits. Here is the reason the Fed cannot control these deposits.”
https://www.dlthornton.com/images/services/Some%20Thoughts%20About%20Inflation%20and%20the%20Feds%20Ability%20%20to%20Control%20It.pdf
The FED has lost control:
Bank Credit, All Commercial Banks (TOTBKCR) is on a tear.
https://fred.stlouisfed.org/series/TOTBKCR
Matthias
Jul 31 2022 at 5:05am
Huh? Why would minimum reserve requirements be even a tool that’s available in a ‘free’ economy?
People should be free to enter into any contract they wish. Including contracts for loans and deposits.
If I wanted to put my money in a bank that doesn’t keep any Fed dollars around, but instead invests everything into gold, why shouldn’t I be allowed to do that?
(It might be a bad idea not to have any reserves. But that’s just a business decision that the market can judge.)
No, in a free economy the Fed can mostly do exactly what it does now in terms of monetary policy; they would just lose their monopoly on issuing currency. So if you don’t like their policy, you’d be free to use some private currency or Euros or whatever.
Spencer Bradley Hall
Jul 31 2022 at 9:50am
Because bank lending is not self-regulatory. The “unseen hand” simply does not function in this area. Invariably the systems created too much money, speculation became rampant, inflation distorted and destroyed economic relationships, confidence that the banks could meet their convertibility obligations eroded, “runs” on the banks caused mass banking failures, and entire economies were left in ruin.
Spencer Bradley Hall
Jul 31 2022 at 9:59am
The reason why a Central Bank must use legal reserves is that interest rate manipulation doesn’t work, the money supply doesn’t work, etc. The only thing that works is the rate-of-change in legal reserves (which I used ever since the money supply errors in 1979).
Spencer Bradley Hall
Jul 30 2022 at 8:57am
Jerome Powell doesn’t have a clue. He has destroyed deposit classifications, which isolated money intended for spending, from the money held as savings and overstated deposit volumes (RRPs). If banks were true intermediaries, we wouldn’t have this problem.
There is no “Fool in the Shower”. Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman and Anna J. Swartz (“Money and Business Cycles”), monetary lags are not “long & variable” (A Monetary History of the United States, 1867–1960, published in 1963).
The 24mo rate-of-change in short-term money flows, the volume and velocity of money, the proxy for inflation in American Yale Professor Irving Fisher’s truistic “equation of exchange” is at the highest roc in history. The prospect is for secular stagnation
Spencer Bradley Hall
Jul 30 2022 at 9:00am
The distributed lag effect of monetary flows are not “long and variable”, but have been mathematical constants for > 100 years.
We knew the precise “Minskey Moment” of the GFC:
AS I POSTED: Dec 13 2007 06:55 PM |
The Commerce Department said retail sales in Oct 2007 increased by 1.2% over Oct 2006, & up a huge 6.3% from Nov 2006.
10/1/2007,,,,,,,-0.47 * temporary bottom
11/1/2007,,,,,,, 0.14
12/1/2007,,,,,,, 0.44
01/1/2008,,,,,,, 0.59
02/1/2008,,,,,,, 0.45
03/1/2008,,,,,,, 0.06
04/1/2008,,,,,,, 0.04
05/1/2008,,,,,,, 0.09
06/1/2008,,,,,,, 0.20
07/1/2008,,,,,,, 0.32 peak
08/1/2008,,,,,,, 0.15
09/1/2008,,,,,,, 0.00
10/1/2008,,,,,, -0.20 * possible recession
11/1/2008,,,,,, -0.10 * possible recession
12/1/2008,,,,,,, 0.10 * possible recession
RoC trajectory as predicted.
Grand Rapids Mike
Jul 30 2022 at 6:25pm
One opinion is that Powell did not start to raise rates in 2021 because he wanted to be nominated for a second term. So it was a convenient excuse to support the transitory inflation line of BS. Biden also needed his spending to be monetized and Powell just complied. His (Powell) reward is his 2nd term.
It is sorta interesting that the magical Modern Monetary Theory (MMT) was gaining some traction around 2020-21 and there seemed to be developing a core of magical MMT believers. In the end it was just a ruse to support more fed spending.
Now it seems that many still think inflation is transitory, that just a few hikes in interest rates and it will all settle down. To some its seems the magical MMT still applies.
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