When it comes to inflation, the Federal Reserve seems to be suffering from confirmation bias. No matter how many new clues keep challenging the Fed’s fundamental belief that today’s inflation is but a transitory phenomenon, the Fed clings to its view that inflation will soon return to its 2 percent inflation target. By so doing, the Fed risks falling behind the inflation curve and allowing inflation expectations to become entrenched.
So far this year, the Fed has proved to be a poor inflation forecaster. At the start of the year, the Fed believed the Personal Consumption Expenditure deflator, its favorite inflation measure, would increase by 1.8 percent in 2021. But that inflation measure is now running at 3.6 percent and showing no signs of slowing. Worse yet, far from being anchored, household inflation expectations for the year ahead have crept up to 4 .5 percent, and consumer price inflation is running at more than 5 percent.
The Fed believed high inflation would be transitory because it expected international commodity prices to soon decline. Yet international oil prices keep rising and currently stand at around $80 a barrel, almost double their level last year. Meanwhile, global food prices are some 33 percent higher than a year ago while, ahead of the winter, global natural gas prices have risen to record levels.
Another reason why the Fed thinks the spike in inflation will be temporary is its belief that COVID-19-induced global supply chain disruptions will soon be repaired. Yet we now learn from Asian producers that the semiconductor problem plaguing the automobile and appliance industries will not be resolved until well into 2022 at the earliest. We’re also learning that high international shipping costs are here to stay.
In taking an optimistic view on inflation, the Fed also seems to have turned a blind eye to housing costs, which constitute around 40 percent of the Labor Department’s consumer price index. Never mind that in response to the Fed’s ultra-easy monetary policy, housing costs are increasing nationally by some 18 percent a year while rental costs are increasing by around 9 percent. These strong increases in home prices and rents almost guarantee that the housing component of the consumer price index will exert upward pressure on that index for many months to come.
More fundamentally, the Fed seems to be minimizing the risk that its policies will soon lead to an overheated economy. In particular, it seems to be ignoring the fact that at a time that the U.S. economy has received as much as 25 percent of GDP in budget stimulus over the past two years, the Fed has maintained the most expansive monetary policy conditions in more than a decade. It has done so both by maintaining interest rates at close to zero and by continuing to buy $120 billion a month in U.S. Treasury bonds and mortgage-backed securities.
The upward drift in wages and the widespread complaints across many industries about labor shortages and about the need to pay sign-up bonuses to attract workers are all indications that overly expansive aggregate demand policies could lead to worrying wage-price pressures. Another indication is that job openings have skyrocketed to a record of more than 10 million jobs, which now exceed the number of people out of work.
Perhaps the Fed will ultimately be proven correct in its optimistic view that inflation will soon return to the Fed’s targeted path. But if that occurs, it will be despite an overwhelming number of clues pointing in the opposite direction.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.