After adopting a more flexible policy framework in response to the low inflation conditions leading up to the Covid-19 crisis, the US Federal Reserve now finds itself faced with an entirely different economic regime. The balance of power therefore weighs heavily on decisive action to control today’s price increases.
November 24, 2021 | Raghuram G. Rajan
In the United States, price increases spill over to all goods and services, and inflation can also be seen in large-scale business inputs such as transportation, energy, and, increasingly, labor. -work. How should we expect central bankers to react?
For its part, the US Federal Reserve has stressed that it will only consider raising interest rates after gradually reducing its monthly asset purchases, which will take place in July 2022 at the current rate of unwinding. Nonetheless, some members of the Fed’s Federal Open Market Committee fear that the central bank fell behind at that time, forcing it to raise rates more sharply, to higher levels, and for longer than expected. For example, Fed Vice President Richard Clarida recently indicated that the Fed may consider stepping up the cut (so it can raise rates sooner) when its members meet again in December.
Despite growing (but often unspoken) concerns from the Fed, central bankers are now reluctant to view inflation as a problem. In the past, current levels of inflation would have made them straighten their shoulders, stare determinedly at television cameras and say, “We hate inflation and we will kill it” – or words to that effect. But now they’re more likely to make excuses for inflation, assuring the public that it will simply go away.
Clearly, the prolonged period of low inflation after the 2008 global financial crisis – when the Fed struggled to raise the inflation rate to its 2% target – had a lasting impression on the psyche of bankers. central. The obvious danger now is that they could fight the last war. Moreover, even if they do not fall into this trap, structural changes within central banks and in the broader political environment will leave central bankers more reluctant to raise interest rates than they were. in the past.
To adapt to the low inflation environment before the pandemic, the Fed changed its inflation framework to target average inflation over a (as yet undefined) period. That meant he could allow higher inflation for a period of time without being criticized for falling behind – a potentially useful change at a time when rising public inflation expectations were seen as the key issue. Gone is the old central bank adage that if you’re okay with inflation, it’s already too late. Instead, the Fed watched inflation for a while and only acted when it was sure inflation was here to stay.
In addition, the new framework places much more emphasis on ensuring that employment gains are broad and inclusive. Since historically disadvantaged minorities in the United States are often the last to be hired, this change implied that the Fed would potentially tolerate a tighter labor market than in the past and have more flexibility to run the job. economy, which is useful in a low demand environment. Yet the Fed is now facing an environment of strong demand coupled with supply chain disruptions that do not look set to abate quickly. Ironically, the Fed may have changed its policy framework just as the economic regime itself was changing.
But shouldn’t greater flexibility give decision-makers more options? Not necessarily. In the current scenario, Congress has just spent billions of dollars to generate the best economic recovery money can buy. Imagine the wrath of Congress that would ensue if the Fed now weighed on the economy by raising interest rates without using all the flexibility of its new framework. In other words, one of the advantages of a clear inflation targeting framework is that the central bank has the political cover to react quickly to rising inflation. With the new framework, this is no longer true. As a result, there will almost surely be more inflation for longer; indeed, the new framework was adopted – in what now appears to be a very different era – with precisely this result in mind.
But it’s not just the new framework that limits the effectiveness of the Fed’s actions. Anticipating relaxed monetary policy and financial conditions for the indefinite future, asset markets were in tears, supported by heavy borrowing. Market participants believe, rightly or wrongly, that the Fed is supporting them and that it will pull out of a rate hike path if asset prices fall.
This means that when the Fed decides to move, it may need to raise rates in order to normalize financial conditions, implying a higher risk of an adverse market reaction when market participants finally realize that the Fed is serious. Once again, the downside risks of a rate hike trajectory, both to the economy and to the Fed’s reputation, are substantial.
The original intention in making central banks independent of government was to ensure that they could reliably fight inflation and not be forced to directly finance the government budget deficit or maintain borrowing costs. government to a low level by slowing the pace of rate hikes. Yet the Fed now holds US $ 5.6 trillion in government debt, funded by an equal amount of overnight borrowing from commercial banks.
When rates rise, the Fed itself will have to start paying higher rates, reducing the dividend it pays to the government and increasing the size of the budget deficit. In addition, US debt stands at around 125% of GDP, and a significant portion of it is short-term, meaning that interest rate increases will quickly begin to translate into costs of debt. higher refinancing. An issue the Fed did not have to pay much attention to in the past – the effects of rate hikes on the cost of financing public debt – will now be in the foreground.
Of course, all central banks in developed countries, not just the Fed, face similar forces pushing rate hikes to moderate. Thus, the first major central bank to move can also cause the exchange rate of its currency to appreciate significantly, thereby slowing economic growth. This is yet another reason to wait. Why not let someone else do it first, and see if they invite the market and political anger?
If the post-2008 scenario repeats itself, or if China and other emerging markets transmit disinflationary impulses to the entire global economy, waiting will have been the right decision. Otherwise, the current obstacles to central bank action will translate into higher and more sustained inflation, and a more prolonged struggle to control it. Fed Chairman Jerome Powell will have a lot to weigh as he enters his second term.
Raghuram G. Rajan, former Governor of the Reserve Bank of India, is Professor of Finance at the Booth School of Business at the University of Chicago.
Copyright: Project Syndicate