In the recent past, the Fed and US policymakers have been trying to prove that they caused inflation when in reality, it was a pandemic, or even Russian President Vladimir Putin. While the Fed may have won the philosophical battle, the average American may pay the price for that victory. According to CNBC contributor Ron Insana, US policymakers got the inflation wrong in several ways. Inflation was likely caused by a Russian President, a pandemic, or supply chain restrictions.
The Great Inflation
The “Great Inflation” ended after Paul Volcker took the helm of the Fed in 1979, but it had a significant negative impact on minimum wage earners and pensioners. The reason for this lack of indexation is simple: people don’t demand it frequently enough and don’t understand it. A century ago, economist Irving Fisher documented popular misconceptions about inflation. Today, many of those same mistakes still plague us, contributing to income inequality and social discord.
One of the causes of inflation is government debt. After World War I, Germany incurred a large war reparations bill. Other countries in the Global South are similarly dependent on global finance, yet the United States is the world’s largest economy. So how can we get inflation under control? Ultimately, we should aim to create a “run” on the dollar away from government debt while limiting job losses and weak growth.
Interest rate forecasts
Inflation was supposed to rise in the late 1970s and early 1980s, but the Fed and other policymakers were wrong. At that time, the Phillips curve didn’t show a simple trade-off between unemployment and inflation. That concept was supplanted by a newer one – NAIRU, or the non-accelerating inflation rate of unemployment. It’s a new way to think about inflation and the role of the Fed in it.
When the Federal Reserve predicted 1.8 percent inflation in 2021, consumers actually increased their prices by seven percent. That was the highest inflation rate since 1982. While the spike was unanticipated, it was fueled by supply chain disruptions, rising energy prices, and a shift in demand to sectors that had less capacity to maintain low prices. And even if we didn’t think the inflationary trend would last indefinitely, it wasn’t a problem worth risking the economy’s future.
Long-term interest rates
Two long-time Federal Reserve economists argue that rising inflation expectations will not drive inflation this year. Inflation expectations over the long term are lower, and this suggests that people expect prices to decline over time. Hence, the current theory of inflation is wrong. It seems like the Fed got inflation wrong by ignoring the long-run inflation expectations, and has been getting it wrong ever since.
Last month, consumer prices rose 7.5% compared to one year earlier. The gain was the steepest since February 1982. The Fed, along with the White House, hoped that this temporary inflation would pass. But it hasn’t worked. Prices have risen faster than expected and have fed through into wages. The median American consumer had predicted a 6% price increase over 12 months in December. Today, global inflation is 6%.
Supply chain restrictions
We should not be surprised that the Fed and other policymakers are concerned about high inflation. The Fed’s inflation policy is tied to the supply chain mess that bedevils our economies, businesses, and consumers. While the Fed insists that the high inflation is temporary, some economists and policymakers aren’t so sure. While it is too early to judge whether the current high inflation will last, it is possible that it will reach unmanageable levels in the year 2022.
It’s also worth noting that the emergence of an omicron version of COVID-19 may cause a backlog in supply chains. Instances of supply disruptions have been reported in states with lower vaccination rates. Even though Vice President Biden has ruled out lockdowns, an increase in cases could prevent millions of people from returning to work. However, despite the current ominous omens, it’s possible that supply chains will remain constrained for longer.
Public confidence in the Fed
Inflation has been a key issue since the 1970s, when the Fed lowered interest rates. However, a recent trend shows that the Fed has acted more aggressively than it had been able to in the past. The Federal Reserve is removing support for the economy by reducing bond purchases, and communicating plans to raise interest rates. In anticipation of this action, mortgage rates have begun to climb. Last year, former Treasury secretary Lawrence H. Summers warned that inflation would go off in 2019.
Despite warnings from economists, the Fed failed to recognize the differences between the Great Recession and the Pandemic Recession. They also failed to foresee the inflationary consequences of a faster recovery. As a result, they made critical policy mistakes. The Fed’s view of inflation is based on a distorted interpretation of the post-war history of the United States. In the 1970s, stagflation broke out despite resource slack and apparent stability of expectations. In two years, the inflation rate dropped from 12% to 5%, and the Fed expected that the economy would stabilize. In addition, the unemployment rate dropped from 9% to 7%.