Everyone is feeling the pain of rising prices. Until December, the Federal Reserve labeled inflation as “transitory,” thinking it would ease as supply-chain disruptions were resolved. The problem is that current inflation is not just a function of supply-chain issues but is also the result of Fed policy missteps.
First, all inflation is transitory in that we are not in a permanent state of accelerating prices. The real questions are what acceptable inflation is and how long the unacceptable inflation will last.
In developed economies, central banks consider inflation of 2% as “acceptable.” The Fed informally adopted the 2% target inflation rate in the 1990s. However, unlike in economies where price stability is the only central bank mandate, the Fed has the dual mandate of price stability and maximum employment.
A major Fed concern post-2008 was that jobs were not growing as quickly as in prior recoveries. We were 25+ years removed from significant increases in inflation. Since 1990, prices rose at an average rate just under 2%, but post-2008, the rate has been 1.6%.
On the surface this might seem good, but economists discovered that if inflation runs under 2% for significant periods, then we do not maximize output. To combat this issue, the Fed decided in August 2020 to use “average inflation targeting,” whereby it would allow the economy to run at inflation rates above 2% for some time, thereby stoking job creation and economic growth. There are several problems with the Fed’s approach and announcement timetable.
First, the Fed’s approach assumes it can precisely manage inflation. This view was likely assumed because the U.S. has not experienced rapid inflation for decades. In short, the Fed started to feel good about its “success” in combating inflation, but the Fed’s ability to manage the economy has been declining as more business occurs outside of the banking system.
Second, the Fed gave no guidance on how long inflation could run above 2%, nor how high inflation could get as part of the averaging process. This is significant because consumers process information rationally and had come to expect the Fed to rein in inflation as it approached 2%. Now consumers wonder if the Fed is comfortable with a 2.5%, 3% or 4% (or more) rate for an unspecified time. As the Fed allows for higher inflation, consumers start to expect it, creating a self-fulfilling prophecy.
Third, the Fed chose to implement this new approach after pumping $4 trillion into the economy, swelling its balance sheet to almost $9 trillion, at the same time that the fiscal side of the house had put unprecedented amounts of cash into consumers’ hands, with fewer ways to spend it because of COVID restrictions.
Finally, the Fed significantly underestimated the supply-chain problem. In August 2020, its new approach was announced as the world was battling the Delta variant. While the U.S. had largely reopened, countries from which we receive products had lower vaccination rates and/or far stricter lockdown policies when there were outbreaks. In short, as long as we remain on the virus roller coaster, supply-chain issues will remain.
Taken together, these issues suggest that “acceptable” inflation is still a ways off. While supply chains will recover, we still have significant cash piles for consumers to spend, and there has been little new production capacity built to satisfy the increased demand. Finally, the Fed has left consumers and markets to wonder how much inflation is too much before the Fed acts. Unfortunately, when faced with uncertainty, consumers and markets often assume the worst, which here means expectations of higher inflation in the future.
