The Federal Reserve has mishandled the situation. It took up the fight against inflation too late and far too hesitantly. Now it needs pick up the pace, even if it comes at the price of a recession.
Jerome Powell has become noticeably uncomfortable in his own skin. The Federal Reserve chair must now look on as inflation in the U.S. climbs ever higher. At the moment, it is sitting at 8.5%. For that reason, Powell has hinted that he plans to step up the pace at which interest rates are increased. Instead of the baby steps that have been taken up to this point, consisting of increases of 0.25 percentage points, at the next meeting of the Federal Open Market Committee, the federal funds rate could be increased by 0.5 percentage points. Such a step will be “on the table,” Powell said tellingly on Thursday.
A Disastrous Policy of Overheating
It is true that such an announcement will be poorly received by the stock market, where people have gotten used to cheap money. But more decisiveness is needed in the fight against inflation. In the U.S., the feeling of losing control is taking hold. Prices seem to be rising unchecked, having not taken much notice of the Fed’s actions up to this point. Resentment among the population is growing. One poll has shown that almost one in five Americans views inflation as the country’s most pressing problem.
It did not need to get to this point, and it should not have. The Fed can be partially exonerated, as admittedly, higher interest rates will not solve supply chain issues. Supply shortages for energy and food can also not be resolved via monetary policy. Yet the monetary watchdogs are by no means innocent when it comes to the price hike. They have access to powerful instruments for curbing demand — if they are willing to use them.
Powell and his team have lacked this will. Their policies have not smoothed the economic cycle, but intensified it. The Biden administration’s multi-trillion-dollar stimulus packages have been accompanied by a similarly open-handed monetary policy. This combination has resulted in a significant overheating of the economy. For example, an analysis carried out by the Federal Reserve Bank of St. Louis showed that in the fourth quarter of 2021, when the danger of inflation was already blatantly clear, monetary policy was more stimulating than it has been in nearly 50 years.
In other words, at a time when the government was raining money down on the U.S., consumer demand was rising rapidly due to COVID-19 restrictions being lifted, companies were searching desperately for staff and prices and wages were increasing markedly, the Fed further spurred on the economy. The consequences of this pro-cyclical policy are visible today: a rapid loss of purchasing power and a tarnishing of the monetary watchdogs’ credibility.
The Risk of Runaway Inflation
Pursuing an intelligent monetary policy involves taking small steps and avoiding abrupt changes. But that requires foresight and a willingness to tackle problems when they first start to appear. The Fed has never able to bring itself to take such preventive measures in recent times. The price is being paid for this now. The Fed can no longer afford to take the ideal approach involving gradual steps, but must increase the tempo. Powell’s remarks make that clear.
The Fed is in a critical phase. It has to prevent inflation taking on a life of its own and penetrating all the economy’s crevices. It must also prevent the wage-price spiral from getting out of control. The longer inflation remains high, the greater the risk of inflation running away. Consequently, interest rates must swiftly rise to a level where they are no longer stimulating. If that triggers a recession, this should be a price that the Fed is willing to pay, as there is no alternative to inflation control.