The central bank needs to pull back on quantitative easing before it’s too late.
Developments this week have illustrated why we should be more worried about the increasing probability that a monetary policy mistake risks derailing a potentially strong and transformational U.S. economic recovery — assuming, that is, that market accidents don’t happen first, the probability of which is also increasing.
The two big U.S. inflation measures — the consumer price index and the producer price index — again came in hotter than consensus expectations. Such inflation data overshoots have become common worldwide, reflecting the extent to which both economists and policy makers are still playing catch-up with events on the ground.
The fact that both CPI and PPI are running hot is consequential. It suggests that realized inflation is being accompanied by additional inflation in the pipeline. This goes against the Federal Reserve’s often repeated conviction that inflation is transitory, especially now that base effects have mostly played themselves out.
Look for this corporate earnings season to confirm three inflation dynamics that those talking to corporate leaders have heard again and again: that wages are rising in an increasingly more generalized fashion; that supply and transport bottlenecks are likely to continue for a while; and that companies are confident about passing a portion or all of the various drivers of higher costs to their selling prices.
The other notable development this week came in Fed Chair Jerome Powell’s semiannual testimony to Congress on Wednesday, when he acknowledged that inflation has been coming in above the central bank’s expectations and lasted longer. Yet when it came to policy implications, he immediately reverted to the often-repeated “transitory” mantra to support no change to the policy stance. New York Federal Reserve President John Williams delivered a similar message on Monday, confirming that two of the three most influential Fed officials — and the ones that markets listen to most closely — remain fixated on maintaining ultra-stimulative policies notwithstanding the repeated underestimation of both growth and inflation.
The longer this configuration persists, the greater the risk of a monetary policy mistake. This is particularly true now that Fed policy is governed by a policy framework that has shifted the trigger for action from forecasts to outcomes. Indeed, having resisted pressure to be specific with two key policy influencers — the length of time for assessing transitory inflation and the quantitative definition of “flexible average inflation targeting” — the Fed can continue on this path for a while. And it will probably do so given the Fed’s other conviction, which a growing number of economists also worry about: that the central has the policy tools to react quickly and effectively if need be and, importantly, without causing economic and financial disruptions.
The facts on the ground, as well as the Fed’s traditional emphasis on risk management and building up policy insurance, call for the world’s most powerful central bank to start easing its foot off the stimulus accelerator. For example, it should cut back the mortgage component of the $120 billion of monthly asset purchases, an element fueling an already red-hot real estate market that is pricing many Americans out of new houses without any notable economic benefit elsewhere. By refusing to do so, the Fed runs a higher risk of having to slam the policy brakes down the road. This comes with the threat of the Fed inadvertently engineering a recession, as Bill Dudley, the former New York Fed president, has reminded Bloomberg readers and listeners in the past few weeks.
This inconsistency between data and Fed policy reactions is not new. In fact, this week is a replay of a couple of similar episodes in the past couple of months. But the underlying pressure is building with each one, fortunately still moderately for now.
The longer the economy-policy disconnect continues, the greater the risk-taking by a marketplace that has been conditioned to expect and profit from ample and predicable Fed liquidity injections and the greater the risk of market accidents. There have already been three near accidents this year. Should generalized market disruptions not be avoided next time around, the Fed would face even greater policy challenges given the adverse spillbacks to the real economy.
In the past few weeks, a growing number of economists and corporate leaders have joined the call for a more open mindset when it comes to assessing the nature and persistence of the current inflationary pressures. There is also evidence of greater division within the Fed, with at least three regional bank presidents publicly voicing support for an earlier taper than what the top Fed leadership favors.
Fortunately, there is still a window to avoid both a policy mistake and a market accident. But the window is closing, risking with it not just the durability and strength of an inclusive economic recovery but also the Biden administration’s transformational economic program.