After a decade of low growth and inflation, Federal Reserve
Chairman Jerome Powell unveiled a new strategy a year ago in which the central
bank would keep interest rates lower for longer.
Reality has dealt Mr. Powell a different and unexpected
challenge: the biggest inflation spike in decades. Consumer prices rose 5.4% in
July from a year earlier.
Mr. Powell heads into the Kansas City Fed’s annual
conference this week at the center of the debate over how long the currently
higher inflation will last, and what the Fed should do about it.
He is managing internal disagreement and weathering external
criticism, with economic recovery thrown into renewed turmoil by the rise of
the Delta variant.
Some central bank officials expect the recent price surges
to reverse on their own, allowing the Fed to stick to the approach Mr. Powell
outlined a year ago, intended to generate inflation slightly above 2%. Others
see dangers that high inflation will persist, requiring the central bank to
consider raising interest rates sooner or more aggressively than they had
anticipated to force it down.
For now, Mr. Powell is siding with the first camp but
stresses the outlook is uncertain given the unprecedented state of the economy.
He speaks Friday at the conference, which is being conducted virtually for the
second straight year.
The annual gathering has been a staging ground for high
drama in the past, including 2008, when officials grappled with a deepening
financial crisis, and 2014, when then-European Central Bank president Mario
Draghi laid the groundwork for a new bond-buying campaign.
Last year at the meeting, Mr. Powell unfurled the change in
the Fed’s approach to inflation, and this year he is expected to clarify the
central bank’s position.
At stake is the fate of an economic recovery that has been
far stronger than Fed officials forecast, with output exceeding its
pre-pandemic level by the spring, but unemployment still higher and jobs far
fewer than before the coronavirus prompted large swaths of business and social
activity to shut down last year.
If Mr. Powell gets Fed policy right—reversing its easy-money
policies at just the right pace—inflation should recede over time, the economy
will continue growing and the labor market can fully heal. If he gets it wrong,
pulling back too slowly or too quickly, Americans could struggle for years with
higher inflation or a sharp economic downturn.
During his 3½ years at the helm of the central bank, he
shifted from raising rates to cutting them in 2019, amid a chaotic trade war
and frequent criticism from then-President Donald Trump. Last year, he launched
the most aggressive response in the central bank’s history to stop a financial
panic and avert a depression as the economy shut down. Fed officials cut
interest rates to near zero and began large-scale asset purchases to spur
economic growth by encouraging Americans to borrow and spend.
Prices of vehicles, travel and commodities plunged steeply
at first, then began climbing this spring, as the economy’s reopening
accelerated. The Fed had anticipated some rebound, and by April, Mr. Powell was
playing down worries about one-time price surges, arguing they would prove
transitory.
But prices in the three months that followed rose more
rapidly than Fed officials anticipated. Mr. Powell has indicated he still
expects price pressures to ebb but is preparing for the possibility they don’t.
“There’s absolutely no sense of panic,” Mr. Powell said at a
news conference last month. “My best estimate is this is something that…is
really a shock to the economy that we’ll pass through.”
Most economists agree with Mr. Powell that the recent
inflation surge is mostly due to temporary factors, such as shortages of
supplies like microchips and rental cars, and of workers. But many of them,
including at the Fed, failed to anticipate two things that have amplified price
pressures and could continue fueling them for longer, officials said in
interviews and public remarks.
First, bottlenecks have been more severe than anticipated.
New waves of Covid-19 cases around the world due to the Delta variant, along
with uneven vaccine distribution, threaten to disrupt supply chains for longer
than hoped.
Second, Fed officials didn’t expect Congress and the White
House to pump so much federal aid into the economy this year, which
supercharged consumer demand as U.S. vaccination rates and business reopenings
were taking off. Last December, the outgoing Trump administration and Congress
approved $900 billion in new aid. Then in March, President Biden and Congress
agreed to a $1.9 trillion assistance package.
Higher inflation that results from supply-chain bottlenecks
won’t be a serious problem for the Fed if it eases on its own. But decisions
could become thornier if inflation stays high.
When higher inflation results from restricted supply,
raising rates doesn’t solve the problem, as the European Central Bank
discovered after raising rates in 2008 and 2011 because of higher oil prices.
The move curbed demand rather than increasing supply, ultimately worsening
economic damage and making inflation too low in the ensuing years.
“There’s a question of whether you want the Fed tightening
into a supply-side shock. Destroying demand isn’t the way to do it,” said Diane
Swonk, chief economist at accounting firm Grant Thornton.
The Delta variant also threatens to delay a rebound in
travel and leisure spending. The Kansas City Fed last week scrapped plans for
this week’s conference, the Jackson Hole Economic Policy Symposium, normally
conducted in Wyoming’s Grand Teton National Park, to be held in person.
President Biden is weighing whether to offer Mr. Powell a
second term, to begin in February. Mr. Biden’s team has said they agree with
the Fed’s inflation outlook, but the president will have to make his decision
before he knows whether it pans out. “We will keep a careful eye on inflation
each month and trust the Fed to take appropriate action if and when it’s
needed,” Mr. Biden said this month.
Mr. Powell, who has returned to a mostly empty Fed building
for work three or four days a week, faces the immediate task of forging
consensus among the Fed’s internal factions over how and when to reverse their
easy-money policies. That is proving tricky because officials are still trying
to iron out the new approach to inflation he unveiled at Jackson Hole a year
ago.
That policy framework aims to halt a decadeslong decline in
inflation, which before the pandemic had reached levels that Fed officials
deemed too low.
Under the previous approach, the Fed would raise interest
rates as unemployment fell to prevent inflation from exceeding 2%. Now,
instead, it would hold off lifting rates pre-emptively and allow inflation to
rise above 2% to make up for past shortfalls in inflation. But officials never
defined just what that would look like.
Part of the current problem is that the new policy framework
was designed to address a different challenge from what the Fed now faces. The
new framework aimed to push inflation gradually higher by using low interest
rates to fuel stronger demand. Now, because of the pandemic, the U.S. economy
is facing the biggest supply disruption in recent history, pushing inflation
far above the Fed’s target.
That is raising questions over how the Fed should respond if
inflation falls somewhat, but not all the way back, to its 2% goal over the
next year or two.
One growing group of officials is more nervous about the
inflation surge and believes the economy no longer needs the gusher of easy
money that has flooded the system over the past 18 months. They want to start
winding down the Fed’s asset purchases sooner and more quickly than the others,
making room to raise rates earlier if necessary.
Another camp thinks inflation is more likely to ease on its
own over time. They worry that if they tighten policy prematurely, they will
slow the economy too much, causing inflation to fall below their target again
and making it harder to lift it.
Mr. Powell falls somewhere in between. He has brushed aside
talk of raising rates, but during his tenure he has often adopted a
“risk-management” approach that preserves the Fed’s ability to shift course if
the outlook changes quickly. Tapering the Fed’s $120 billion a month in
purchases of Treasury and mortgage securities sooner or faster than previously
anticipated would provide such flexibility.
Officials have pledged to continue that buying until the
economy gets closer to the Fed’s inflation and unemployment goals.
Core prices, which exclude volatile food and energy costs,
rose 3.5% in June from a year earlier, according to the Fed’s preferred gauge,
the personal-consumption expenditures price index. That was the highest rate in
30 years. Rising prices over the April-to-June quarter largely reflected
disrupted supply chains, temporary shortages and a rebound in travel.
The drivers of those price gains may be fading, recent
evidence suggests. Used car prices in July have risen 42% over the previous
year, but they rose just 0.2% from June. Airfares rose 19% over the past year,
but they declined 0.1% in July from June. In June, categories that make up 8%
of the core price basket were responsible for more than 60% of price increases
that month.
While inflation has surged in other countries, the increase
in the U.S. has been in part because of greater fiscal support, economists say.
Through the first few months of 2021, Mr. Powell urged his
colleagues to not talk about withdrawing easy money to demonstrate their
commitment to the new framework and to avoid confusing markets. In March, most
Fed officials projected they wouldn’t need to raise rates through 2023.
In April, Fed officials introduced language in their heavily
debated postmeeting statement to pre-empt worries about higher inflation
numbers by saying they were “largely reflecting transitory factors.”
Some chafed against the Fed’s position. Dallas Fed President
Robert Kaplan argued against including the language. “It doesn’t reflect what
I’m seeing,” he said in a recent interview. Business contacts have warned him,
for example, that shortages of semiconductor chips, an important component in
new cars, are going to go on potentially for years because the industry will
struggle to keep up with higher demand.
Outside critics also piled on. In the 1950s, then-Fed
Chairman William McChesney Martin Jr. quipped that the Fed’s job was to take
away the punchbowl when the party was revving up. “Now, the Fed’s doctrine is
that it will only remove the punchbowl after it sees some people staggering
around drunk,” said Lawrence Summers, the former Treasury secretary to
President Bill Clinton, at a May conference.
As the Fed’s June 15-16 meeting approached, the surging
inflation numbers made the central bank’s earlier projections less tenable. On
the Saturday before that gathering, Mr. Powell was surprised to learn most
officials had penciled in at least two rate increases by 2023.
Markets mostly took the new rate projections in stride. But
they led some analysts to question whether the Fed was stepping back from its
view that inflation pressures would be transitory.
Mr. Powell is betting that more workers will return to the
labor market as schools reopen, vaccinations make people less risk-averse and
more-generous unemployment benefits expire. That should help ease some price
pressures by moderating wage growth.
“Americans want to work, and, and they’ll find their way
into the jobs that they want,” he said last month. “It may take some time,
though.”
Inflation might stay higher than the Fed expects if wage
growth accelerates or if other sectors of the economy that haven’t contributed
to stronger prices, like residential rents, rise in the coming year.
St. Louis Fed President James Bullard, in a recent
interview, said he thinks the Fed will need to start raising rates next year to
tamp down inflation.
When the pandemic hit, it was reasonable to think that it
would exacerbate the low-growth, low-inflation world that had preceded it, Mr.
Bullard said. Instead, aggressive government support, along with vaccines,
boosted economic output above its pre-pandemic level this spring, something
that took years after the 2008 recession. “This has turned out to be a very
different type of macroeconomic shock than the global financial crisis,” he
said.
Boston Fed President Eric Rosengren said he also thinks the
Fed needs to begin rethinking its current easy-money stance. He thinks workers
in high-contact service industries may be able to demand higher pay if Covid-19
proves more persistent, creating an “upward tilt” to wages and prices. As a
result, it is possible “we’re not going to continue to have as difficult a time
achieving our 2% inflation target as we did coming out of the financial
crisis,” Mr. Rosengren said in an interview.
Others are nervous about overreacting. Chicago Fed President
Charles Evans told reporters this month he thinks the pre-pandemic dynamics in
which inflation, interest rates and global growth were historically low will
eventually reassert themselves. He sees core inflation returning to around 2.1%
at the end of next year.
“I know I’m going to be very regretful if we claim victory
on averaging 2%, and then we find ourselves in 2023 with about a 1.8% inflation
rate sustainable going forward,” he said. “I’m probably more nervous than
almost all of my colleagues.”
Click here for the
original article.