Monetary Policy Emerging from a Pandemic

At NIESR, Paul plays a key role in forcing us to address in our internal discussions on the causes of inflation and the need for a central bank response. I think at the time of our autumn UK Economic Outlook we reached an overall position that could be characterised as recognising that there is a lot of economic uncertainty as we emerge gingerly from Covid-19, but that central bank targets, instruments and communications seem to be adding to, rather than detracting from, uncertainty. In the old days, when inflation shot up, so did policy rates: simple rules were nice, right?

What is the cause of the current spike in inflation?

Fire needs three ingredients to take hold – fuel, heat, and oxygen. The three ingredients feeding the current US inflationary fire are excess demand, fuelled by massive fiscal stimulus, heat caused by supply shortages, and the oxygen of super-lax monetary policy.  As an example, until the pandemic, durable goods prices were falling steadily for a generation, but in November they were up 14.9% on November 2020. The reason?  A rise of over 22% in the real consumption of durables (note that it was not a fall, which the supply-shortages story would imply), stoked by tax cuts and a switch away from services.  House prices are up roughly 20% on a year earlier.  Slack policy is the main contributor to the current inflation, with supply restrictions lighting the match.

Do you think that there is a risk that it will persist, and why?

The risk is very substantial.  Inflation has not yet peaked.  The headline annual CPI rate will end the year at 7% or above.  It should fall next Spring as chunky month-on-month increases this year drop out of the twelve-month comparison.  However, the whole distribution of inflation is shifting to the right, with already-registered increases in house prices set to add further to CPI inflation in 2022 and 2023 through rents and owner-occupiers’ imputed rents (together about 40% of the core CPI).  And yet higher manufacturers’ prices and wholesale price rises are still to feed through to consumers.  Meanwhile, wages are picking up, thanks to high inflation and a tight labour market, which is lifting services price inflation and will continue to do so.  The Fed will overshoot its 2% inflation target by a considerable margin for a considerable period.  The public’s inflation uncertainty is the highest for forty years, which means that the risk of inflation expectations de-anchoring is significant, especially if there is another inflationary shock.

What should the Fed do in terms of policy rates, QE and communication?

US policy is a destabilising mess.  Fiscal policy has been excessively stimulatory but is now going to subtract from growth just when inflation is hurting real incomes.  Monetary policy has been too slack for too long and getting back on track must take time otherwise there will be an asset price and economic shock.  If the Fed aims to hit its 2% target even by 2023 it will burst the multiple asset price bubbles it has blown, including in the housing market, and send the economy into a tailspin.  It needs to re-establish its credibility, which is severely damaged, by first holding itself accountable for its errors, second, producing credible inflation forecasts, and third, committing to reduce inflation progressively over time.  This strategy will entail higher rates, beginning in the first half of 2022.  The Fed should phase out QE no later than April 2022 and start hikes soon after.  The longer it waits, the greater the chances of either inflation becoming totally unanchored or it having to provoke a recession to get rid of it.

What is your opinion of the Federal Reserve’s inflation target? What do you think it should be?

Advising on a policy action from the Fed unconditional on its targets is like setting out on a journey without knowing where you’re going – you’ll end up somewhere you don’t want to be.  The Fed wants to be in multiple places at once – it has an inflation target, wants to achieve maximum employment, with this being inclusive, and aims for moderate interest rates.  It gives no guide as to what it views as acceptable trade-offs between these objectives, so its reaction function is opaque.  Even its inflation target is fuzzy.  The Fed aims to average 2% inflation over an unspecified period and for inflation “moderately higher than 2%” for a period.  Not even the Fed knows what his means.  The 2% inflation target is too low because it comes with an excessive risk of being stuck at zero interest rates.  A 3% target would be far preferable but is politically unpalatable, so the Fed’s stated objectives and its actions will continue to be inconsistent.

How will this inflation episode end?

The future is uncertain and how this plays out depends critically on what the Fed’s policy is going forward. Given the current high rate of inflation and strong signals that the inflationary shock is spreading out through the economy, the chances of a benign scenario, where inflation fades away of its own accord and the Fed does not a have to take serious steps to combat it, look slim. The alternatives are that the Fed continues to accommodate inflation and that significantly above target inflation becomes entrenched – not runaway inflation but rates considerably higher than 2%. The third scenario is that ultimately, the Fed realises it must tighten policy to contain inflation and that this, sooner or later, provokes a rupture in asset markets, including the housing market, and provokes a severe recession. The trouble is that the Fed has set about responding to the significant economic challenges around Covid with the analysis and mindset appropriate to how is met the challenge of the global financial crisis. It is not a good idea to prepare to fight the last war, but that’s what the Fed has done, and that’s why it is losing the current battle against inflation.