OPINION: “With inflationary pressures now going from transitory to pervasive, the policy rate should be the first line of defense, not the final shoe to drop.”
NEW HAVEN, Conn. —The transitory inflation debate in the United States is over. The upsurge in U.S. inflation has turned into something far worse than the Federal Reserve expected. Perpetually optimistic financial markets are taking this largely in stride. The Fed is widely presumed to have both the wisdom and the firepower to keep underlying inflation in check. That remains to be seen.For its part, the Fed counsels patience.
The Fed believed, as did many, that the pandemic shock of early 2020 was cut from the same cloth as the 2008-09 global financial crisis, underscoring the possibility of yet another anemic, disinflationary recovery that could push already-low inflation dangerously toward deflation. Balance-sheet miracles But there is an added complication—the Fed’s belief in the magical powers of its balance sheet. Like average inflation targeting, quantitative easing was also born of recent crises. Ben Bernanke, first as Fed governor, then as chair, led the charge in cataloging the endless list of unconventional policy options that a fiat monetary system has at its disposal when the nominal policy rate nears the zero bound.
Think again. Now the Fed must normalize in the face of an inflation shock. This calls into question the glacial process envisioned in a low-inflation normalization scenario. The Fed has failed to make this important distinction. It has telegraphed a mechanistic unwinding of the two-step approach it used in the depths of the crisis. The Fed views normalization simply as a reverse operation—reining in its balance sheet first and then hiking the policy rate.
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