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Fed chair Jerome Powell speaks after being nominated for a second term as Lael Brainard looks on following her nomination as the next Fed vice-chair, at the Eisenhower Executive Office Building in Washington, DC, on November 22. Photo: Getty Images/AFP
Opinion
Stephen Roach
Stephen Roach

US Federal Reserve must get creative and act fast to end inflation spiral

  • Despite the flashing warning signs, the Fed remains wedded to a monetary policy born of the low-inflation past
  • With inflationary pressures going from transitory to pervasive, the policy rate should be the first line of defence
Stephen Roach
Stephen Roach
Why you can trust SCMP
The transitory inflation debate in the US is over. The upsurge in inflation has turned into something far worse than the Federal Reserve expected. It is presumed to have the wisdom and firepower to keep underlying inflation in check, but that remains to be seen.
The Fed counsels patience. It is so convinced its forecast will turn out to be correct that it is content to wait. No surprise there – the Fed telegraphed such a response with its “average inflation targeting” framework last year.

In doing so, the Fed indicated it was prepared to forgive above-target inflation to compensate for years of below-target inflation. Little did it know what it was getting into.

In theory, average inflation targeting made sense – an arithmetic consistency of undershoots balanced by overshoots. In practice, it was an inherently backward-looking approach, conditioned by a long experience with slow growth and low inflation.

Like many, the Fed believed the pandemic shock of early 2020 was similar to the 2008 global financial crisis, underscoring the possibility of another anaemic recovery that could push already-low inflation dangerously towards deflation.

Ever since the dotcom bubble burst, Fed policymakers have worried about Japan-like stagnancy for the US economy with lost decades of economic stagnation and persistent deflation.

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Japan beef bowls and coffee costing more as workers feel the pinch from food price hike

Japan beef bowls and coffee costing more as workers feel the pinch from food price hike

Those concerns are understandable if a crisis hits when inflation is already close to zero. But, by fixating on such risks, the Fed all but ignored the possibility of major upside inflation.

That is exactly what has happened. Thanks to an explosive post-lockdown rebound in aggregate demand, which the Fed played a key role in fuelling, already-stressed global supply chains snapped.

Today’s price and cost pressures are too numerous to count. Transitory one-off price adjustments became pervasive, and a major inflation shock is at hand.

But there is an added complication – the Fed’s belief in the powers of its balance sheet. Like average inflation targeting, quantitative easing was also born of recent crises.
Ben Bernanke led the charge in detailing the list of unconventional policy options the monetary system has when the nominal policy rate nears zero. He first couched this in terms of a thought exercise in 2002, stressing the Fed’s capacity for liquidity injections via asset purchases should deflationary risks mount.

But when reality came close to the hypothetical in 2009, Bernanke’s script became an action plan – as it did again during the Covid-19 shock of 2020. While out of basis points at the zero bound, the ever-creative Fed was never out of ammunition.

The challenge comes with restoring monetary policy to pre-crisis settings. For both the conventional benchmark policy interest rate and the unconventional balance sheet, the US central bank has yet to figure this out.

The Fed faces two complications. First, unwinding ultra-accommodative monetary policies is a delicate operation that raises the possibility of corrections in asset markets and the asset-dependent real economy.

Next move for China’s interest rates should be up, not down

Second, there is confusion over how long it takes to return policy to its pre-crisis settings. That is because, until now, there has never been an urgency to normalise.

Persistently low inflation would give an inflation-targeting central bank leeway to feel its way down the road. Now the Fed must normalise in the face of an inflation shock. This calls into question the glacial process envisioned in a low-inflation normalisation scenario.
The Fed has failed to make this distinction. It has telegraphed a mechanistic unwinding of the two-step approach it used during the crisis. The Fed views normalisation as a reverse operation – reining in its balance sheet first and then raising the policy rate.

While that might be appropriate in a low-inflation environment, an inflation shock makes it unworkable. The preferred first step is likely to have only a limited impact on the real economy and inflation.

The Fed needs to reassess its approach to policy sequencing. With inflationary pressures going from transitory to pervasive, the policy rate should be the first line of defence.

The federal funds rate is at minus 6 per cent in inflation-adjusted terms, deeper in negative territory than in the mid-1970s. My advice: up the ante on creative thinking. With inflation surging, stop defending a bad forecast and forget about tinkering with the balance sheet.

Get on with the heavy lifting of raising interest rates before it is too late. Independent central bankers can afford to ignore the political backlash. I only wish the rest of us could do the same.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate

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