2022 has been a year full of uncertainties for the global economy so far, and it looks like it will continue. Rising inflation, the invasion of Ukraine, and supply chain problems arising from China and Russia… None of this makes the Fed’s job any easier. But even before all this, the Fed had begun to have struggled in its monetary policy path. While the recent rate increase is one step towards solving this, it is not enough. War is a factor that will pour the uncertainty and the Fed seems to be struggling to find its way through all this.
There are two ways to think about current inflation. First, supply chain problems started with Covid-19 and worsened again with the invasion of Ukraine. It is not the Fed’s job to solve all this; moreover, that is well beyond its ability. You simply cannot expect the Fed to solve the problem in Ukraine. The Fed may take steps to offset the implications of supply chain problems as it did from early 2020 to mid-2021, but nothing more.
The second cause of inflation is directly linked to monetary policy – overexpansionary monetary policy. This is where things got complicated in mid-2021. When the Fed announced its new framework, FAIT, in 2020, it meant offsetting the previous undershoot with an overshoot to keep inflation at 2% over the long run. There was a lot of confusion about FAIT, some of which was the Fed’s miscommunication, the rest due to pundits’ failure to internalize the new framework. Still, the Fed did pretty well until mid-2021: the Fed should be praised for its achievements, such as the unprecedented rate of labor market recovery and the NGDP’s return to the trendline. But at the same time, supply chain problems persisted, and the Fed seemed somewhat reluctant to tighten monetary policy, even as NGDP reached its trend level.
Unfortunately, this was the cause of the problem after mid-2021. Indeed, given the Fed’s framework, what they should have done simply was to start tightening monetary policy in the fall of 2021, as inflation had already reached the desired level, the labor market recovery is over, nominal wages were skyrocketing, and the NGDP had already exceeded its trend level. Although the Fed seems to have implicitly abandoned FAIT at this point, I have to admit that I believed in the new regime and had a good plan. Sadly, the Fed later abandoned FAIT entirely.
When we look at the TIPS spreads, we can clearly see that the Fed faces a major failure. Markets expect an extra 9% inflation throughout 2020, not an average of 2% inflation. This had to be a scenario that the Fed would not want and would not allow happen in any case. Worse, the abandonment of FAIT makes the conditions for a recession even more convenient and dramatically reduces the likelihood of the Fed making a soft landing.
Don’t get me wrong, I’ve supported FAIT and the Powell regime all the way through 2021, and I think their success is momentous. Bringing the labor market back to trend level is more than a miracle. However, some mistakes could destroy your previous achievements, and the Fed seems to be going that route.
One of the biggest mistakes that can be made is to attribute current inflation entirely to supply chain problems. While this was true until the fall of 2021, this is no longer the case. High inflation can sometimes have two causes, and we live in one of those unfortunate times. In the 1970s, there were oil shocks due to the war, and global wheat prices soared due to the Soviet Union. While we have similar supply chain issues today, all of that doesn’t explain the whole picture. Overexpansionary monetary policy is the cause of the problem. In 2008, the real problem was nominal; even though we are in the opposite scenario today, the real problem is still nominal. And it’s not just about raising interest rates. The Fed can raise interest rates at will, and still we can have high inflation and an overexpansionary monetary policy, which will cause a recession. The problem is the policy regime and its abandonment. This results in a fatal loss of credibility, and most of the things you do have no payoff.
The Fed needs to restore its credibility and tighten monetary policy urgently, not allowing supply chain issues to distract from its focus. A Fed that has lost its credibility will probably never even dream of a soft landing, and everything Powell’s Fed has accomplished will be meaningless. Of course, this is easier said than done. Bernanke’s inability to ease monetary policy sufficiently in 2008 may be due to something similar: the Fed has been institutionally reluctant to take certain steps. George Selgin noticed this, but the Fed seemed to have overcome it in 2020. Now we are going through the same thing all over again.
Everything that has happened in recent months seems to have made the Fed’s job very difficult, but I still think soft landing can be achieved. The rest will depend on Jay Powell’s talent.
