The Fed’s contradictory behavior shows that it is in a bind
A clash of views seems to have emerged within the Federal Reserve (Fed). On the one side, Chairman Jerome Powell has repeatedly told Congress and the nation that they need not worry about a recent acceleration in inflation, that it is “transitory” and so requires no change in monetary policy. On the other side, Fed policy makers have begun to take the inflation threat more seriously and have begun, albeit tentatively, to drain liquidity from the financial system.
This conflict between words and action certainly will not help Washington recover public confidence, but of greater concern is how this latest Fed effort has pointed up the great difficulties policy makers will face if in fact they must mount an anti-inflation campaign. Not only would the Fed then have to reverse years of extremely easy monetary policy, but it would face a particular problem of its own making, for its policy of paying interest on bank reserves has effectively, if inadvertently, placed an inflation bomb in the center of the country’s financial system.
Chairman Powell’s easy dismissals notwithstanding, recent inflation news certainly looks troubling and worthy of a policy rethink. The Labor Department’s consumer price index has risen so far this year at a 7.3% annual rate. That compares to 0.2% last year and an average of 1.5% a year during the prior five years, 2015-2019.
Producer prices have risen at more than a 10% annual rate so far this year, compared with 0.5% last year and an average rate of close to zero inflation during the prior five years. All other price measures have followed similar patterns, as have the prices of metals and other critical industrial materials. Food prices are rising so fast that supermarket chains are stocking up on inventories to get ahead of the next price hike.
This news has unavoidably raised concerns and questions. Many remember or have studied the economic harm caused by the great inflation of the 1970s and 1980s. More than just painful memories, many are also aware of the inflationary potentials of the extremely easy money policies the Fed has pursued for years now, since 2008 in fact.
In 2008, the Fed had little choice but to push interest rates down to zero and redouble the monetary ease by directly entering markets to buy bonds, what the Fed refers to as “quantitative easing.” Without this help, markets would have collapsed and dragged the whole economy down with them. As it is, the country suffered the worst recession since the Great Depression. Normally, the Fed would have unwound such policies once the economic recovery began, but the recovery following the crisis of 2008-2009 was so slow that policy makers kept the extreme stimulus going.
Tentative efforts to moderate the stimulus did begin in 2014 but only very gradually. Then in 2019, policy again became easy, ostensibly to alleviate the strains of the “trade war” with China. The pandemic in 2020 brought a return to zero interest rates and still greater injections of liquidity into markets.
With this history as background, it is easy to see why some want a considered response from Chairman Powell. Rather than give that, he and others in the administration seem determined only to deflect all questions. Both Powell and Treasury Secretary Janet Yellen have assured all and sundry that the recent inflation spike is purely a statistical artifact of the interruptions caused by the pandemic and has nothing to do with more than a decade of low interest rates and easy money.
Even President Biden has gotten into the act, assuring people that the inflation was “expected” and is expected to dissipate soon. One might wonder what the president means by “expected,” since the 2021 inflation failed to appear in either last year’s economic projections from the White House Budget Office or the Fed.
Against such nonsense, it offers some comfort that some at the Fed have begun to act. They have left interest rates low, no doubt because a rise in rates would have called attention to their inflation concerns and caused panic in financial markets. They have, however, begun to reverse the flood of funds they had previously poured into markets through quantitative easing programs. Technically, what they have initiated are called “reverse repurchase agreements.”
What they amount to is Fed sales of some of the bonds bought over the years. The action has drawn what could be inflation-causing liquidity out of financial markets. The effect has shown in the money supply, the key link, both historically and in theory, to inflation. The broad M2 measure of money, which had been growing at a 25% annual rate, has slowed during the spring quarter to about a 10% annual rate of growth.
The Fed will have to do a lot more if this recent inflation persists. Policy will, in fact, have to reverse a good part of the huge liquidity buildup of the last ten-plus years. That would be a monumental chore under any circumstances but especially now because of the Fed’s 2008 decision to begin paying interest on the reserves banks keep at the Fed. When the Fed paid no interest on these deposits, policy management was more straightforward. Banks, because they earned nothing on their reserve deposits, kept them to the minimum required by law. All the reserves the Fed injected into the system were lent out promptly, while those the Fed reabsorbed just as quickly caused banks to pull back from lending.
But since the Fed started to pay interest on these deposits, this close relationship has loosened. Since reserves began to earn interest, banks have accumulated them, sometimes blunting the effect of liquidity injections on the economy but also creating a cushion against any liquidity withdrawals by the Fed. At present, more than 90% of these reserves held by banks at the Fed are in excess of amounts required by law. Should the banks flow these excess reserves back into lending, they could easily confound any anti-inflation effort to remove liquidity from the system.
It is then little wonder that Chairman Powell wants to dismiss the inflation. Any other response would require him to explain how he might change policy to cope, and that in turn would force him to describe the difficult situation the Fed faces, especially how it is, at least in part, of the Fed’s own making.
Though behind his smoke screen policy makers have begun to act, the steps the Fed has taken so far, as should be clear, will hardly be enough if the inflation lasts. A little more transparency from Washington’s “experts” might ease the necessary policy transition, but getting that is probably more difficult than even the inflation fight would be.