Because the Federal Reserve made a historic mistake about inflation. Economist Report
The Federal Reserve, writes The Economist, has suffered a "hair-raising" loss of control. What comes next will set the course for the world economy
Central banks should inspire confidence in the economy by keeping inflation low and stable. The US Federal Reserve suffered a hair-raising loss of control. In March, consumer prices were 8.5% higher than a year earlier, the fastest annual increase since 1981. In Washington, observing inflation is usually the prerogative of experts in shabby offices. Now nearly a fifth of Americans say inflation is the country's biggest problem; President Joe Biden has released oil from strategic reserves to try to curb gasoline prices; and Democrats are looking for the bad guys to blame, from greedy bosses to Vladimir Putin – writes The Economist .
It is the Fed, however, that had the tools to stop inflation and failed to use them in time. The result is the worst overheating in a large, wealthy economy in the 30-year era of inflation-oriented central banks. The good news is that inflation may finally have peaked. But the Fed's 2% target will remain a long way off, forcing the central bank to make tough choices. American policymakers apologists point to annual price hikes of 7.5% in the euro zone and 7% in Britain as evidence of a global problem, driven by soaring commodity prices, especially after the Russian invasion of Europe. Ukraine. Nearly three-quarters of euro zone inflation is attributable to soaring energy and food prices.
But America benefits from abundant shale gas, and its higher incomes mean that commodities have less effect on average prices. Taking away energy and food, inflation in the euro zone is 3%, but the US inflation is 6.5%. Furthermore, the American labor market, unlike the European one, is clearly overheating, with wages growing at an average rate of nearly 6%. Recent falls in oil, used car and shipping prices likely mean inflation will drop in the coming months. But it will remain too high given the underlying upward pressure on prices.
Uncle Sam was on a unique path due to Biden's excessive $ 1.9 trillion fiscal stimulus, which passed in March 2021. It added further energy to an economy that was already recovering quickly after multiple cycles. of spending and brought the total pandemic stimulus to 25% of GDP, the highest in the rich world. As the White House pressed the accelerator, the Fed would have to apply the brakes. He did not. His hesitation stemmed in part from the difficulty of predicting the path of the economy during the pandemic and also from the tendency of politicians to fight the war. For most of the decade following the 2007-09 global financial crisis, the economy was stalled and monetary policy was too tight.
Yet the Fed's failure also reflects an insidious shift among central bankers globally. As our special report in this issue explains, many around the world are dissatisfied with the stable business cycle management job and want to take on more fascinating tasks, from fighting climate change to minting digital currencies. At the Fed, the change was evident in promises to pursue a "broad and inclusive" recovery. The rhetorical twist ignored the fact, taught to every undergraduate economist, that the unemployment rate at which inflation takes off is not something central banks can control.
In September 2020, the Fed codified its new views by promising not to raise interest rates at all until employment has already reached its sustainable maximum. Her promise guaranteed that she would fall far behind the curve. It was applauded by leftist activists who wanted to imbue one of Washington's few functional institutions with an egalitarian ethos.
The result was a mess that the Fed is only now trying to clear up. In December, it forecasted a paltry interest rate hike of 0.75 percentage points this year. An increase of 2.5 points is expected today. Both politicians and financial markets think this will be enough to bring inflation to a halt. They are probably too optimistic again. The usual way to keep inflation in check is to raise rates above their neutral level – which is thought to be around 2-3% – for more than the rise in underlying inflation. This indicates a federal funds rate of 5-6%, not seen since 2007.
Such high rates could tame the rise in prices, but generate a recession. Over the past 60 years, the Fed has only managed to slow down the US economy significantly on three occasions without causing a recession. It never did after letting inflation soar as high as it does today.
A US contraction then looms over the global economy as part of a trio of risks, alongside Europe's energy security and China's struggle to suppress Covid-19. Poor and middle-income countries, in particular, have a lot to lose from a steep rate hike by the Fed, which will squeeze capital and weaken their exchange rates, especially if a global downturn simultaneously reduces demand for their exchange rates. exports.
Does the Fed have the stomach to inflict such economic trauma? Many economists argue for higher inflation, because in the long run, interest rates would rise hand in hand, raising them further from zero, below which they are difficult to cut in a crisis. Inflation is already helping the federal government by reducing the real value of its debts. Around 2025, when the Fed revises its policy framework, it will have a chance to increase the target. There is nothing special about the 2%, except that the Fed has promised it in the past.
Inflation stable and modestly above 2% might be tolerable for the real economy, but there is no guarantee that the Fed's stance today will guarantee that too. And breaking promises has consequences. It hurts long-term bondholders, including foreign central banks and governments that own $ 4 trillion in Treasury bonds. (A decade of inflation at 4% instead of 2% would cut the purchasing power of money repaid at the end of that period by 18%.) It could add an inflation risk premium to America's cost of borrowing. And even if America fails to deliver on its inflation promises in troubled times, investors may worry that other central banks – many of which are watching over their shoulders at indebted governments – would do the same. In the 1980s the recessions brought about by Paul Volcker's Fed laid the foundation for inflation-targeting regimes around the world. With every month that inflation runs too high, some of that hard-earned credibility fades.
(Extract from the foreign press review by eprcomunicazione )
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/perche-la-federal-reserve-ha-fatto-un-errore-storico-sullinflazione-report-economist/ on Sat, 23 Apr 2022 05:43:38 +0000.