Although Federal Reserve Chair Jerome Powell’s comments on the Fed’s role in reducing inflation are almost a year and a half late, Powell finally understands that it is the Federal Reserves’ primary responsibility to ensure price stability. Had he realized that early last year, the country would not be experiencing the near 9% inflation today.
Powell finally says the Fed is ready to take “forceful and rapid” action. If he had said that in March 2021, he could have taken “forceful and gradual” action.
The best measure of consumer inflation is the Consumer Price Index (CPI), which truly reflects the increase in prices faced by the average consumer. The Fed looks at a different consumer inflation measure called the Personal Consumption Expenditure (PCE), which measures price increases and anticipated consumer reaction to those increases.
If the price of beef increases by 10%, that number is factored into the CPI. But the PCE says consumers will buy less beef and substitute a lower-priced product like fish, which reduces the price increases for them. Although that is likely to be true, the inflation rate actually faced by the consumer reflects the full increase in the price of the beef.
The PCE will always be lower than the CPI and is not an accurate indicator of price increases facing consumers. Still, the PCE is currently 6.3%. The Fed target is 2%.
Prior to the pandemic, the CPI increased by 0.1% or 0.2% per month, on average. That led to an annual inflation rate in the 2% range. In January 2021, the CPI increased by 0.3%; then 0.4% in February, 0.6% in March and 0.8% in April.
Clearly, there was an inflation problem building. Yet Powell, and the entire Biden administration, insisted the inflation was temporary or transitory — even though there is really no historic precedent for transitory inflation. On the other hand, there are plenty of examples that show some inflation turning into runaway inflation.
The Fed waited until March of this year to finally completely end its bond-buying program and start to raise interest rates. By then, annual inflation exceeded 7%. Yet the Fed moved slowly, raising interest rates by only 25 basis points.
Realizing that was too little, the Fed got more aggressive. In May, it raised rates 50 basis points. In June and July, interest rates were raised by an aggressive 75 basis points each of those months.
The Fed just completed its annual closed-door meeting in Jackson Hole, Wyoming. Based on Powell’s comments, it looks like the chairman of the U.S. Federal Reserve will finally get it right.
HOW INFLATION ROCKETED TO A 40-YEAR HIGH
There are three goals for monetary policy: price stability, full employment and economic growth. Last year, even though the economy was growing at an annual rate of nearly 6% and there was a developing labor shortage, the Fed abandoned its goal of price stability.
The Fed continued to rapidly expand the money supply by purchasing $120 billion per month of government bonds, and it kept interest rates near zero for the entire year. That shockingly irresponsible monetary policy pumped so much excess demand into the economy that inflation soared to a 40-year high.
“Central banks can and should take responsibility for delivering low and stable inflation,” Powell said last week. “Our responsibility to deliver price stability is unconditional.”
Why didn’t Powell say that in March of last year?
At that time, he could have reduced inflation by gradually raising rates and guided the economy to a much softer landing. Since he is so far behind, the Fed must continue to be very aggressive, meaning it will raise rates by another 75 basis points in September and probably raise another two times by year-end.
Powell admits that will be painful, but the cost of entrenched inflation where consumer psychology changes so they expect inflation, is much higher. “History shows that the employment costs of bringing down inflation are likely to increase with delay,” Mr. Powell said. “Our aim is to avoid that outcome by acting with resolve now.”
Why didn’t he say that a year and a half ago?
LABOR AS SHOCK ABSORBER
Fortunately, the labor shortage we are currently experiencing will mean the Fed’s actions will have a much smaller negative impact on unemployment. That will make the recession less severe. Usually, when the Fed takes drastic action like this, the unemployment rate rises significantly, as was the case in the early 1980s when the unemployment rate soared to double-digit levels.
Then-Fed Chair Paul Volker, recognizing that inflation was very high and had pervaded throughout the 1970s, raised interest rates to double-digit levels. It did bring inflation down to an acceptable level, but it also brought on a very severe recession.
It is good to see that Powell finally recognizes the inflation problem and seems committed to fixing it.
“We will keep at it until we are confident the job is done,” Powell said.