Fed's Inaction Risks Allowing Inflation to Persist
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Chapter 1: Introduction to Federal Reserve Actions
The Federal Reserve appears to be making another misstep.
Beginning in June of last year, I believed the Fed was on the right track, asserting that maintaining price stability would be their primary focus. Following seven consecutive significant interest rate hikes, they opted to decelerate their approach. Instead of a substantial seventy-five basis point increase, they transitioned to twenty-five basis point increments, ultimately opting for a pause with no rate increase at all. This halt could allow inflation to persist, and potentially escalate by late summer.
Throughout 2021 and into early 2022, the Federal Reserve enacted an irresponsibly expansionary monetary policy. During this time, the economy expanded at a 6% rate, while the federal government engaged in deficit spending nearing $3 trillion for two consecutive years.
By maintaining interest rates at near-zero levels and injecting an additional $240 billion monthly into the economy via government bond purchases, a significant excess demand was generated. The inevitable outcome of this strategy was a sharp rise in prices.
In June 2022, after inflation peaked at an annual rate of 9.1%, the Fed finally adopted a more aggressive stance. Chair Jerome Powell emphasized that restoring price stability was now the Fed's utmost priority. At that juncture, it seemed necessary for the Federal Funds Rate to reach at least 6% to effectively rein in inflation to a manageable 2% level.
Ronald Reagan once remarked that inflation is a detrimental condition that must be treated vigorously in its early stages. Failing to do so can result in inflation becoming embedded within wage contracts and consumer expectations, as was the case in the 1970s.
The Fed should have continued implementing seventy-five basis point increases for at least one additional occasion, which would have led to a 6% Federal Funds Rate. Instead, they opted for a less aggressive approach and subsequently paused.
Section 1.1: The Challenge of Forecasting Inflation
Accurately predicting future inflation is a complex task. Much of the uncertainty is tied to energy prices, which comprise roughly 30% of the Consumer Price Index (CPI). Currently, oil prices remain below $75 per barrel, with global demand subdued, largely due to China's ongoing struggle to fully revive its economy post-COVID lockdown.
If oil prices were to rise to $100 per barrel, as some economists speculate, inflation could worsen significantly. Conversely, if oil prices remain stable, our core inflation rate still hovers above 5.3%. The longer it remains in this range, the more challenging it will be to reduce that figure.
The Fed has stated that while price stability is still their principal goal, they also have concerns regarding their secondary and tertiary objectives: full employment and economic growth. In essence, they aim to steer clear of a recession.
They have expressed a desire for a "soft landing," where inflation is curbed while simultaneously slowing the economy without triggering a recession.
However, this objective may prove quite challenging. Should they miscalculate, the inflation dilemma may worsen.
Section 1.2: Job Market Dynamics Amid Economic Changes
Chair Powell has anticipated an increase of approximately two million in the unemployment rate as a consequence of the Fed's monetary policy, although this estimate may be exaggerated. Currently, about 10 million job openings exist, while there are approximately 6 million unemployed individuals. This disparity highlights a labor shortage.
In the event of a recession, this situation could be advantageous. As economic activity slows and revenue declines, businesses may opt to halt hiring before resorting to layoffs. Moreover, with a multitude of job vacancies, unemployed workers may find it easier to secure new employment. Some economists have labeled the anticipated recession as a "full-employment recession."
It appears that the impact of the recession may be relatively mild. There remains excessive demand within the economy. While the Fed's actions have certainly contributed to moderating this demand, the federal government is still projected to overspend by $1.6 trillion this year. Additionally, consumers seem more tolerant of rising prices than in previous years.
The economy continues to generate jobs at a robust pace, and retail sales are experiencing rapid growth. Consumers are actively spending, despite the prevailing inflationary pressures.
In conclusion, interest rates should be increased by an additional seventy-five basis points. Rather than pausing, the Fed should adopt a more assertive stance. Inflation is akin to a cancer that requires early and aggressive treatment.