How did the Fed get it so wrong on inflation?

Whether rising inflation reflects a transitory phenomenon or a more pernicious and lasting surge in average price levels has been a much-debated issue. Recent data suggest that high inflation is likely to persist for longer than the Federal Reserve (the Fed) had projected. While a few economists (Paul Krugman and Brad DeLong) remain in the transitory inflation camp, most now view surging inflation as a serious problem.

Many economists (most notably, Olivier Blanchard and Larry Summers) warned early and often that the inflation risk was real this time around. The failure of Fed officials to realize the fundamental differences between the Pandemic Recession and the Great Recession, along with an inability to envisage the inflationary consequences of a dramatically faster rebound this time around, contributed to critical policy errors.

The 2008 financial crisis resulted in deficient aggregate demand that persisted for multiple years as overleveraged households and financial institutions focused on repairing their balance sheets. Furthermore, the rise of the tea party movement and backlash against bank bailouts brought about an early and abrupt end to fiscal stimulus. (The so-called “fiscal cliff” actually led to a negative fiscal impulse even before a full recovery had been achieved.)

Financial frictions, low consumer confidence and heightened uncertainty led to muted consumption spending between 2009 and 2016. Given the U.S. economy’s utter dependence on household consumption expenditure, it is not surprising that both economic growth and job market recovery was underwhelming during the post-financial crisis period. It was only after the restoration of stimulative fiscal policy in 2017-18 that we saw growth reinvigorated.

During the pandemic shock, unprecedented levels of fiscal stimulus and aggressive monetary policy interventions quickly restored aggregate demand. Furthermore, the U.S. economy entered the pandemic recession from a position of considerable strength. Unemployment was near historic lows in Feb. 2020, and both American households and major U.S. financial firms had healthy balance sheets prior to the pandemic shock.

Stimulus checks, generous unemployment benefits, surging asset prices (both equity and real estate values hit record highs) and historically low borrowing costs meant that the spending power of American households was more than fully restored. In fact, with “excess saving” accumulated during lockdowns, the real challenge has been to find adequate supply to satisfy all the pent-up demand.

Unlike the post-financial crisis recovery, the current one is characterized by a persistent struggle to boost aggregate supply at both the national and the international level. While shifts in spending patterns (such as the increased demand for durable goods) have posed a challenge, other factors have contributed to the general inability to raise production sufficiently to meet the surge in demand.

Significant and ongoing labor market dislocations and churn have created critical labor shortages around the world. Nominal wage growth has risen sharply as workers, especially low wage earners, finally attain some bargaining power. The fact that the underlying full-employment level may have shifted following the pandemic shock has failed to register with Fed officials, many of whom continue to insist on returning to pre-pandemic levels. 

A global supply-chain built for efficiency failed on the resiliency front as the pandemic shock revealed the fragile nature of the highly interconnected system. Nobel laureate Michael Spence recently noted that “participants in global supply chains increasingly predict that the shortages, backlogs, and imbalances between supply and demand will persist well into 2022, and perhaps longer.” Fed officials have failed to fully grasp the extent and duration of supply-chain disruptions.

Rising energy costs and surging food prices have added an additional layer of complexity. Spikes in rents are creating further hardship for many American households. These developments are likely to keep inflation at elevated levels for the foreseeable future.

Ultra-loose monetary policy bears direct responsibility for some of these outcomes. By artificially keeping a lid on the risk-free rate and by lowering the risk premium, the Fed provided a strong impetus for stocks and other risky assets to surge. This not only added to the speculative fervor but through a positive wealth effect further juiced aggregate demand. 

Furthermore, historically low interest rates and ongoing purchases of mortgage-backed securities have led to a real estate boom that has boosted home-equity drawdowns, priced out first-time home buyers and generated a surge in rental prices. Yet, many Fed officials appear surprisingly nonchalant about the role their policies have on asset prices and broader societal trends (such as rising income and wealth inequality).

New research suggests that ultra-low borrowing costs is most beneficial for superstar firms. The top 5 percent of companies in each industry were found to gain the most from the low borrowing costs. A troubling feature of the American economy in recent decades has been the growth in market concentration.

Importantly, market-based inflation expectations and interest rate signals appear increasingly distorted, as the Fed has become the biggest player in the U.S. Treasury bond market. Consumer survey-based measures clearly suggest that inflation expectations have in fact surged in recent months. With economic overheating a growing concern, it is apparent that negative real interest rates are not what is needed in this environment.

If the Fed were to reverse course quickly, there is still a possibility that this recovery can be put on a more sustainable track. At the upcoming Federal Open Market Committee meeting in December, the central bank should announce a more rapid pace of tapering and signal to markets that a rate hike in June or July of 2022 is on the cards. 

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.