It is tempting to give the US Federal Reserve credit for its about-face in tackling inflation. It is equally tempting to give President Xi Jinping credit for his stewardship of a rising China. Neither deserves it, and for a similar reason.
That is certainly true of today’s Fed. The US central bank has raised the federal funds rate (FFR) by 75 basis points
three times in a row. Politicians and pundits are howling in protest, but I disagree. It was past time for the Fed to start digging itself out of the deepest hole it has ever been in.
My emphasis is on the word “start”. The nominal FFR, now effectively at 3.1 per cent, remains 5 per cent below the three-month average of the headline inflation rate. Notwithstanding the Fed’s determination to arrest a serious outbreak of inflation, it is all but impossible to accomplish that with a real FFR of around -5 per cent.
Fed chair
Jerome Powell has said a restrictive monetary policy is needed to tame inflation. Based on headline inflation, the neutral policy rate – basically an average of the real FFR from 1960 to 2021 – is 1.1 per cent. Restrictive must then be a number greater than neutral; for the sake of argument, call it a 2 per cent real FFR. The Fed is not even close to being neutral, let alone restrictive.
This is where the debate gets tricky. Powell said on September 21 that Fed policy was in the lower end of the restrictive zone. He framed that judgment through the lens of underlying inflation measured by the “core personal consumption deflator”, which excludes food and energy. Annual core inflation on this basis was at 4.6 per cent through July.
This is disappointing for two reasons. The nominal FFR is well below Powell’s favoured inflation metric, and the Fed’s fixation on core inflation is dangerous. That latter point was true in the early 1970s, when I was part of the Fed’s staff that created the core, and it is true today.
The premise of the core is to dismiss major price shocks as transitory, just as
Powell initially did. I am still haunted by the “original sin” of my first boss, Fed chair Arthur Burns, who ignored one transitory shock after another some 50 years ago until it was too late. A Fed that lives by the core can die by the core.
For China, the “core” is less about inflation and more about the personal dimension of leadership. Xi, China’s “
core leader”, is at the crux of an extraordinary regression in Chinese governance.
Unlike the “reform and opening up” policies that began under Deng Xiaoping, the heavy hand of the Xi-centric Communist Party is everywhere. That is especially the case with the
regulatory assault on internet platform companies, and in the new push towards income and wealth redistribution under the guise of “common prosperity”.
I stand by my initial assessment of the combined impact of these developments: the emergence of an “animal spirits deficit” that could inhibit Chinese entrepreneurial activity, new start-ups, indigenous innovation and productivity. With
an ageing China hitting the demographic wall sooner than many had feared, the lack of a productivity offset is all the more disturbing in constraining the economy’s growth potential.
The same can be said for China’s consumers. The animal spirits deficit can only reinforce their concerns about an uncertain future, perpetuating the fear-driven
precautionary saving that has long inhibited Chinese consumption.
The Fed’s fixation on core inflation and the overreach of China’s core leader share one important feature: susceptibility to major policy blunders. To the extent monetary policymakers continue to be misled by an inflation problem that is more intractable than a focus on core inflation suggests, they and the financial markets underestimate the kind of monetary tightening required to return inflation to a 2 per cent target.
The nominal FFR might have to rise to 5 to 6 per cent to accomplish that, implying the Fed could be only halfway into its inflation control campaign. That spells recession in the United States in 2023. China, which is in an
unusually sharp slowdown, is unlikely to be an oasis of growth. A global recession next year is almost inevitable.
To the extent that China’s core leader is blinded by a
fixation on ideology and unprepared for the harsh economic climate ahead, his troubles could be only just beginning. That is an ironic prospect so near to the 20th Party Congress, which is expected to bestow on Xi a third five-year term as China’s leader.
Just as a fixation on core inflation can mislead central banks, the power of a core leader is a recipe for misdirected, unsustainable policies. The notion of a core lends a false sense of precision to solutions of complex problems. That is true of both inflation targeting and national governance. The core fixation is just as dangerous for the US as it is for China.
Stephen S. Roach, a former chairman of Morgan Stanley Asia, is a faculty member at Yale University and the author of the forthcoming Accidental Conflict: America, China, and the Clash of False Narratives (Yale University Press, November 2022). Copyright: Project Syndicate 
