The Fed Is Underestimating the Risk of Inflation
The data suggest prices will continue to increase, but the bank is guilty of faulty analysis.
Economists routinely make mistakes in forecasting, and such mistakes are often forgiven. But recent errors by the Federal Reserve are deeper analytical blunders. As with any activity that claims to have professional status, economics must respect elementary arithmetic.
From May 2020 to May 2021 the price index for personal-consumption expenditures, or PCE, rose 3.9%, while the consumer-price index jumped 5%. The inflation outbreak has come as a shock to many economists. The latest numbers have undoubtedly required top officials and researchers at the Federal Reserve to revise their thinking.
The Fed considers the PCE index the most reliable indicator of price trends. The Federal Open Market Committee predicted in June 2020 that the increase in the PCE in the year to fourth quarter 2021 would be between 1.4% and 1.7%. At its June 2021 meeting the band was increased to between 3.1% and 3.5%, still too low. The 200-basis-point adjustment is the largest since the instability of the Great Recession more than a decade ago.
Now the Fed is saying that consumer inflation will be less than 3.5% by the end of the year, even as the underlying data tell a different story. Between the fourth quarter of 2020 (taking the average of three months) and May 2021, the PCE index increased 2.5%. In other words, the bulk of the 3.9% price increase has happened in 2021. So far in 2021 the typical monthly increase has been between 0.4% and 0.5%. If that trend continues unabated, the end-year numbers would be on the order of 5% or 6%.
The FOMC might still be right, but it’s clearly assuming that upward pressure on prices will weaken. Have such pressures been weakening or intensifying so far in 2021? What is the reality facing American business and finance? One way to assess the evidence is to check the results of business surveys. Among the most widely cited and well-regarded is the purchasing managers index from the Institute of Supply Management.
The prices index in the May 2021 survey was 88%, slightly down from April but appreciably higher than November (65.4%) and December (77.6%). This suggests prices will continue to rise. The survey for services has a similar message. The typical monthly increase may even be higher in the remaining months of the year, as the increase in the PCE index in the year to the fourth quarter of 2021 could reach the supposedly unimaginable figure of 7%.
The Fed has been dismissive of concern, describing the upturn in inflation as “transitory.” But it can’t deny that the forecasts it made in the spring and summer of 2020 missed the mark by a wide margin. Its main concern then, according to FOMC minutes, was that the Covid-19 pandemic would result in a long period of disinflation lasting “many years,” which would have to be countered by “accommodative” financial policies. In fact, the sequel to the pandemic is an inflationary boom.
Research at the Fed is dominated by the New Keynesian school. According to the New Keynesians, actual inflation is heavily influenced by inflation expectations, with some role for excess demand and supply (measured by the so-called output gap). New Keynesians—such as Richard Clarida, the Fed’s vice chairman—pay little attention to the quantity of money. Over the past remarkable 15 months or so of highly accommodative policies, the FOMC minutes haven't once referred to any concept of the quantity of money.
The omission is all the more remarkable because June 2019 to June 2020 saw the highest increase in the M3 money aggregate since 1943, at 26%. (The M3 aggregate is no longer estimated by the Fed. The figure given here comes from the Shadow Government Statistics consulting firm, using information still made available by the Fed.) Avant-garde New Keynesians might pooh-pooh the comparison as irrelevant to the 21st century. Maybe so, but it can’t be overlooked that in the year leading to March 1947 consumer prices climbed by more than 20%.
The Fed was wrong a year ago, but forecasting errors are a defining feature of modern economics. Today, a case can be made that the Fed is underestimating the inflation risks in the balance of 2021. The FOMC’s latest verdict on inflation relies on inflationary pressures being markedly weaker in the last seven months of the year than they were in its first five months. That seems debatable. Perhaps the Fed has made a less forgivable analytical mistake.
Mr. Congdon is chairman of the Institute of International Monetary Research at the University of Buckingham, England.
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