Prices keep rising in America, and policymakers
are asking how the central bank could let this happen.
Forward guidance I think overall slowed the response
of the Fed to the inflation problem last year.
Investors think more price increases are coming.
By the Fed's count of inflation expectations,
prices will have risen an additional 6.8% by the
summer of 2023.
It turns out that the Federal Reserve might hold
some of the blame.
It is going to be very challenging.
It has been made significantly more
challenging by the events of the last few months.
We need to make sure that the central bank is on the
side of everybody in the country.
The big concern is that not only will we have these big
increases in inflation this year, but that will lead
people to expect higher increases in the future.
Because if that's the case, it sort of compounds upon
itself.
We could be headed to stagflation. Might get
better, but it might get a whole lot worse.
And if it gets a whole lot worse, brace yourself for
uncertainty.
How did the U.S. government misread inflation and what
does this mean for people in the United States?
The Federal Reserve is America's central bank.
The job of the Federal Reserve is to safeguard the
buying power of the dollar and to make interest rate
policy in the public interest.
They're supposed to minimize inflation, maximize
employment.
It does this by working with retail banks that Americans
use. Think Chase, Bank of America, Wells Fargo, etc..
Banks have an account at the Fed the way you have an
account at a bank, and the Fed takes that money and
invests it in Treasury bills, mortgage backed
securities, and pays the bank a little bit of
interest.
The Fed manages the U.S.
money supply. Their decisions can have a large
economic impact, but some believe that Congress's
actions within the economy are much more important.
The Federal Reserve needs to be reformed.
The Federal Reserve needs individuals who are on the
receiving end of monetary policy, not individuals who
are only PhDs in economics, who've never held a job in
the real world and have a penchant for life and are
not affected by zero interest rate policy making
life more difficult for for savers who don't have a
public pension for life.
The Fed's job is complicated. It involves
making predictions about the future, things like, How
much will inflation be a year from today?
And if it's up, what should we do about that?
Experts believe the U.S.
central bank has made important decisions that
drove better outcomes throughout history.
Supporters point to the Fed's strong provisions of
credit during the 2020 recession.
This cash ultimately kept millions of people afloat as
the world locked down.
Also, the bank achieved a balance of low inflation,
cheap lending rates and low unemployment for the better
part of three decades.
This stability minimized price increases while
supporting the creation of many jobs.
But occasionally mistakes are made.
The forward guidance, I think overall on the margin
slowed the response of the Fed to the inflation problem
last year to some extent.
So does that mean it was a mistake? I think in
retrospect, yes, it was a mistake and I think they
agree it was a mistake.
So here are the three big mistakes.
The first was a sharp increase in the money
supply. In recent years, the overall pot of cash in
the Fed's control has grown sharply.
Changes in the money supply can take months or even
years to materialize within the economy.
If the same amount of goods existed in the economy, but
there was twice as much money, then we would think
that the price of everything would double.
This sharp increase initially showed up in the
savings accounts of regular Americans before they
quickly vanished.
Well, from everything that we've seen, that money is
concentrated in the hands of the oldest and the
wealthiest Americans.
What has stuck around is a fierce upward spiral in
prices for goods.
As this dynamic took hold, the Fed kept adding dollars
to the money supply, primarily by printing and
issuing bonds that some say the market didn't need.
The result was the sharpest bout of inflation observed
in more than four decades in the States.
Similar dynamics unfolded around the world, bringing
forth a historic new inflationary era.
Very few households, if you will, ever got to enjoy the
benefits of zero interest rate policy.
Only your biggest borrowers.
Now on to mistake number two.
When it started to raise interest rates, the bank was
doing so at way too slow of a pace.
The Central Bank uses its federal funds interest rate
to counteract this high level of inflation.
Their models suggest that if this interest rate goes
up, that will make inflation go down.
That's exactly what they're trying to do now.
The Central Bank waited until March 2022 to flip the
switch and make lending more expensive.
They started with quarter percentage rate hikes and
have since made bigger hikes. This fast pace of
lift off is a start of a sharp reversal from the past
three decades of policy.
So the Federal Reserve maintaining record low
interest rates for a long period of time sort of led
to some of the largest asset bubbles that we ever
saw. And people who had money sort of going into the
crisis and were able to deploy that capital into the
stock market, into the housing market, have done
extraordinarily well as a result of the Fed's
policies.
The final mistake here was that the Fed waited too long
to act at all.
Early signs of inflation took hold for months before
the Fed took action.
For example, fuel was up more than 50% in November of
2021. Even prices for used cars were up over 30% year
over year in the same time frame.
This was happening as the Fed kept its interest rates
near zero and kept buying massive amounts of bonds.
At the time, the bank called inflation transitory,
hoping it would pass.
So far it hasn't.
As Chair Powell indicated himself, both of us probably
could have used a better term than transitory.
But the Federal Reserve wasn't the only group that
made mistakes during this time.
Economists believe that the federal government played a
very large role in this inflationary spiral too.
Fiscal policy is made by the Congress and the president,
and that involves taxation and spending.
And that's different from monetary policy because it
really affects the amount of money that is going to be
in your pocket, whereas monetary policy works
through the banking system.
So some of the record fiscal stimulus that we saw
coming out of the COVID recession were expanded
unemployment insurance checks, the general checks,
the enhanced child tax credit.
All of those were examples of fiscal policy to try to
get the economy recovered as quickly as possible.
Economists like the famous Milton Friedman believed
that inflation comes from changes in the money supply.
Most of the episodes Milton Friedman looked at were
times when governments which were in deep problems
printed money and handed it out.
So if you remember nothing from this, remember one
thing: if you print money and hand it out, drop it
from helicopters, as Friedman said, you will get
inflation.
The current Federal Reserve Board keeps track of the
supply in a publicly available data set.
See the sharp uptick in 2020?
This money went directly into the hands of actual
people who spent it, saved it or invested the funds.
That creates a fierce rush of demand.
And, at the time, it was outpacing supply of the
goods available, possibly creating inflation.
A lot of that money went into emergency COVID bills
like the American Rescue Plan. The government was
able to spend cash it didn't have because it got
huge loans from the Fed.
And printing money to spend it, printing money to hand
it out, printing money to make transfer payments,
that's exactly what our government did in the last
two years of the pandemic.
It's technically not printing money, but it's,
from an economic point of view, the same as printing
out money and handing it out.
And it causes inflation.
So that is both monetary and fiscal policy.
The next time there's a handout, don't be so easy to
take it. Just bear in mind what got us here.
And that was overly intrusive and aggressive
fiscal policy that was monetized by the Federal
Reserve.
Outside of its own missteps, the government's fight with
inflation was accelerated by various things outside of
their control. Economists call these events black
swans. In the 2020s, these so far have included:
COVID. Supply chain disruptions.
Full scale invasion by Russia into Ukraine.
But when the U.S. government needs someone to respond to
these events, they turn to their Federal Reserve and
whatever the Fed decides to do will then reverberate
worldwide. That's because many businesses settle
transactions with U.S.
dollars, which the Fed controls.
So there is a massive transmission mechanism that
transmits U.S.
monetary policy to the rest of the world.
80 some odd percent of all transactions in the world
are done using the U.S.
dollar and Fed policy influences and dictates
where the U.S. dollar is.
So whatever we do is not contained within the United
States economy.
It affects the global economy.
Dealing with these unexpected shocks is quite
difficult as the Fed wades through other unknowns.
As inflation took hold, some voting seats at the Fed
stayed open. And making matters worse, a key member
was forced to resign in what some believe was an
insider trading scandal.
Other voting members like Michelle Bowman warned of
the danger of excess inflation, but went unheard
in the committee chambers.
The Federal Reserve Board is a massive organization full
of staff who need to know who's my leader going to be.
And Randy Quarles said publicly, had there not been
that level of internal uncertainty and strife, that
the Fed would have been raising rates last year when
it knew policy had become problematic, especially as
it pertains to the housing market, which is the only
form of inflation right now that is in the Fed's
control and it looks like they're trying very hard to
break.
Given that's the situation, it seems like the Fed's
decision to continue to prop up the market was
misguided because that sort of added fuel to the
inflationary fire that we're currently dealing
with.
Economists believe that the Fed now has less ability to
get things back on track without sparking a
recession. It's still possible, though.
To do that, they'll need to rapidly increase lending
rates to what economists call a neutral interest
rate, one where the economy is neither growing or
shrinking too quickly.
The neutral rate is a real interest rate.
It doesn't matter if the neutral rate is 3%, that
means something very different if inflation is 8%
versus if inflation is 2%.
If inflation is going to be high and remain higher, that
means that the neutral rate in the economy is also going
to be higher. Because the price of goods are going
up, we need a higher return to stabilize the economy.
If we were actually measuring inflation in a
consistent manner, the peaks in the seventies and
eighties are actually much more similar to the peak
today than we would have initially thought.
Still, the stories of the past could be relevant
material for today's class of central bankers.
While the mistakes are far and few between, they can
have a profound impact.
And for the record, their good calls can make a big
impact too.
If they hold steady and are committed to breaking
inflation, as was the case with Paul Volcker, then
we'll get to the end of this situation of pain
quicker than if they were to try and draw out,
postpone, delay the inevitable.
So I think at this point the Fed has to stick to its
guns, even if that means taking speculators down.
And that really is what has scared the Fed in the past.
The Federal Reserve is supposed to make monetary
policy in the whole of the public's interest, not just
that of investors.
And this is going to be a test of which they have not
really had to take since 1981.