Why Was The Fed So Wrong About Inflation?
The chair of the Federal Reserve is often referred to as the second most powerful person in the world, after the president of the U.S. But no matter how powerful the job may be, it doesn’t prevent its holders from making big mistakes.
The Fed chair’s power stems from the ability to guide the federal funds rate, which sets the cost of money for the world economy.
And that’s exactly why Fed Chair Jerome Powell’s total miss on the inflation story in 2021 was so devastating.
“Readings on inflation have increased and are likely to rise somewhat further before moderating,” said Powell in April 2021. “However, these one-time increases in prices are likely to have only transitory effects on inflation.”
If only. Year-over-year inflation rose 4.2% in April 2021—the most recent reading was nearly double that rate, up 8.3% year over year in August 2022. Using the Fed’s preferred inflation gauge, PCE inflation is nearly 3 percentage points higher than the Fed’s target rate.
The Fed’s big, ugly inflation whiff meant it’d been forced to ratchet up interest rates dramatically and put its giant balance sheet on a diet.
The Fed policy has forced major declines in stock and bond markets. In fact, 2022 looks like it could be the worst year for investors since the Great Recession.
How did the Fed get inflation so wrong? Let’s take a closer look.
The Global Response to Covid-19
When governments worldwide fought Covid-19 by restricting travel and shuttering their economies in early 2020, markets went into a tailspin.
Stocks dropped, the bond market cratered, and oil prices went negative. Central banks worldwide cut interest rates to zero and reassured citizens that they would do what it took to keep credit markets functioning properly. The Fed did its bit by slashing rates and restarting its quantitative easing (QE) program.
The gambit worked with an unprecedented $2.2 trillion U.S. fiscal stimulus bill: Bond markets stabilized, stocks recovered, and household budgets were fortified through direct payments and expanded unemployment insurance.
Throughout the latter part of 2020, Powell agitated for another massive Congressional relief package.
“Too little support would lead to a weak recovery, creating unnecessary hardship for households and businesses,” Powell said in October 2020, roughly seven months into the Covid-19 pandemic. “The recovery will be stronger and move faster if monetary policy and fiscal policy continue to work side by side to provide support to the economy until it is clearly out of the woods.”
A few months later, Congress passed a $900 billion relief package. Several months after that, Congress passed yet another relief bill, this time to the tune of $1.9 trillion.
The federal government spent roughly $5 trillion to aid the national economy in response to Covid-19 lockdowns and restrictions.
Over the same period, the Fed added more than $3 trillion to its balance sheet through long-term bond purchases. It would tack on more than $1 trillion more by spring 2022.
All in all, the rescue packages worked a little too well.
Who’s Afraid of a Little Inflation?
Heading into 2021, analysts were forecasting robust economic growth. Vaccinations would let millions of Americans return to their pre-Covid lives with stimulus-fattened bank accounts. Folks were ready to spend and had the means to do it.
Few were concerned that inflation could take off. Those who sounded the alarm, like former U.S. Treasury Secretary Larry Summers, were quickly dismissed.
During the Great Recession, many economists and pundits argued that the federal government’s $1 trillion bailout would push prices higher. They also claimed that the Fed’s zero-interest-rate policy (ZIPR) and QE program would deliver historic levels of inflation.
But inflation never showed up in the wake of the Great Recession.
On the contrary, price growth remained below—sometimes well below—the Fed’s 2% PCE target due in part to the anemic economic recovery. Remember, it took roughly six years for U.S. employment to return to its pre-2008 recession levels, which didn’t consider population growth.
Powell gave a speech amid the pandemic explaining that the Fed would let inflation linger modestly above its 2% target before taking action.
When the nation’s response to the Covid-19 outbreak caused a brief recession in early 2020, Powell and company were prepared to act for as long as possible to get the economy back on track.
That’s why he was so forthright about acting big and bold. He didn’t want to do too little and deliver a decade of a plodding economic recovery.
Fighting the Last War
The problem was that the Covid recession was not like the Great Recession.
It officially lasted two months, while the Great Recession lasted from December 2007 to June 2009.
The Covid recession resulted from a sudden lack of goods and services—aka a supply shock—while the Great Recession was caused by a housing market crash combined with a financial crisis—aka a demand shock.
Read More: How Long Do Recessions Last?
During the Covid recession, household and bank balance sheets were much better than they were during the Great Recession.
This time, the economy broke down because world leaders decided it necessary to shut down whole countries, not because massive financial institutions were potentially insolvent.
“My critique of the Fed is that they were generals fighting the last war,” said Nick Sargen, chief economist at Fort Washington Investment Advisors. “They pulled out the playbook from 2008, even though the pandemic was a completely different type of shock.”
That mindset is encapsulated by Powell’s October 2020 speech, in which he ruminated on doing too little rather than too much. That’s why the Fed kept its accommodative monetary policy stance throughout 2021, even as inflation began to spiral out of control.
The Fed Thought Inflation Wouldn’t Last
Several key officials in the Fed and the Biden administration believed inflation would be short-lived, a transitory outcome caused by a combination of supply chain issues, reopening the economy, and calendar quirks.
They held to that thought even as prices kept rising throughout 2021. In his August 2021 Jackson Hole speech, for instance, Powell reiterated his concerns about tightening the economy too much too fast.
“Inflation at these levels is, of course, a cause for concern,” Powell said at the time. “But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary.”
He didn’t want to repeat past mistakes. So the Fed kept buying bonds through early 2022, even as inflation neared 8%.
It was only when inflation had infiltrated the economy that the Fed had no choice but to raise interest rates to lower demand.
The hope is that the Fed can get inflation back down without causing another crushing recession. The fear is that they don’t have the tools to do so.