By Stephen S. Roach
NEW HAVEN, Conn. (Project Syndicate)—The Federal Reserve has turned on a dime, an uncharacteristic about-face for an institution long noted for slow and deliberate shifts in monetary policy. While the Fed’s recent messaging (it hasn’t really done anything yet) is not as creative as I had hoped, at least it has recognized that it has a serious problem.
That problem, of course, is inflation. Like the Fed I worked at in the early 1970s under Arthur Burns, today’s policy makers once again misdiagnosed the initial outbreak. The current upsurge in inflation is not transitory or to be dismissed as an outgrowth of idiosyncratic COVID-19-related developments. It is widespread, persistent, and reinforced by wage pressures stemming from an unprecedentedly sharp tightening of the labor market. Under these circumstances, the Fed’s continued refusal to change course would have been an epic policy blunder.
But recognizing the problem is only the first step toward solving it. And solving it will not be easy.
Math and history
Consider the math: The inflation rate as measured by the c onsumer price index reached 7% in December 2021. With the nominal federal funds rate /zigman2/quotes/210002368/delayed FF00 0.00% effectively at zero, that translates into a real funds rate (the preferred metric for assessing the efficacy of monetary policy) of -7%.
That is a record low.
Only twice before in modern history, in early 1975 and again in mid-1980, did the Fed allow the real funds rate to plunge to -5%. Those two instances bookended the Great Inflation, when, over a five-year-plus period, the CPI rose at an 8.6% average annual rate.
Of course, no one thinks we are facing a sequel. I have been worried about inflation for longer than most , but even I don’t entertain that possibility. Most forecasters expect inflation to moderate over the course of this year. As supply-chain bottlenecks ease and markets become more balanced, that is a reasonable presumption.
But only to a point. The forward-looking Fed still faces a critical tactical question: What federal funds rate should it target to address the most likely inflation rate 12-18 months from now?
No one has a clue, including the Fed and the financial markets. But one thing is certain: With a -7% real federal funds rate putting the Fed in a deep hole, even a swift deceleration in inflation does not rule out an aggressive monetary tightening to reposition the real funds rate such that it is well-aligned with the Fed’s price-stability mandate.
To figure this out, the Fed must hazard an estimate of when the inflation rate will peak and head lower. It is always tough to guess the date—and even harder to figure out what “lower” really means. But the U.S. economy is still running hot, and the labor market, at least as measured by the plunging unemployment rate, is tighter than at any point since January 1970 (on, gulp, the brink of the Great Inflation).
Under these circumstances, I would argue that a responsible policy maker would want to err on the side of caution and not bet on a quick, miraculous round trip of inflation back to its sub-2% pre-COVID-19 trend.