Under Chair Jerome Powell, the Federal Reserve continues to reassure markets and the public that the current inflationary pressures are “transitory.” This conveniently allows the Central Bank to keep interest rates low to ensure the economy is well out of the canyon it may have fallen into due to policymakers’ “pulling the plug” as a result of the COVID outbreak.
However, evidence increasingly suggests that this assessment may be dangerously optimistic. While the Fed attributes rising prices to temporary supply chain disruptions and pandemic-related anomalies, there are signs that inflation is heating up and could spiral out of control if not addressed promptly. This blog post explains why the Fed’s transitory narrative may be flawed, why inflation may be more persistent than they acknowledge, and why delaying action could severely impact the U.S. economy.
Supply Chain Disruptions May Not Be Temporary
The Fed has consistently highlighted supply chain bottlenecks as a leading cause of inflation, suggesting that these problems will sort out as the global economy stabilizes. However, this perspective overlooks the complexity and longevity of these disruptions.
- Global Supply Chains Are Deeply Broken: The pandemic has exposed the vulnerabilities of global supply chains, which were already under stress due to years of underinvestment and geopolitical tensions. Restoring these systems to their pre-pandemic efficiency will take years, not months. For example, semiconductor shortages, which severely affect industries ranging from automobiles to electronics, are expected to persist well into 2023.
- Labor Market Disruptions: The pandemic has brought about lasting changes in labor markets, prompting millions of workers to reassess their careers, retire early, or decline to return to low-wage jobs. This has resulted in ongoing labor shortages in critical sectors, increasing wages and production costs.
- Shipping and Logistics Backlogs: Port congestion, container shortages, and soaring freight costs show no signs of easing. Even as demand stays strong, these structural challenges are unlikely to be resolved quickly.
By dismissing these supply-side challenges as temporary, the Fed risks ignoring the inflationary pressures they will continue to exert on the economy.
Unprecedented Policy Stimulus Is Fueling Demand
Although supply-side issues play a role, the Fed may be underestimating the effect of unprecedented fiscal and monetary stimulus on consumer demand.
- Historic Fiscal Stimulus: Since the pandemic began, the U.S. government has injected more than $5 trillion in stimulus into the economy, which includes direct payments to households, enhanced unemployment benefits, and support for small businesses. This has resulted in consumers holding record levels of savings and experiencing significant pent-up demand.
- Monetary Policy Remains Ultra-Loose: The Fed has kept interest rates close to zero and continues purchasing over $100 billion in assets every month, flooding financial markets with liquidity. This loose monetary policy worsens asset price inflation and promotes risk-taking, which impacts the broader economy.
- Strong Consumer Spending: With vaccinations being administered and the economy reopening, consumers are aggressively spending on goods and services. This surge in demand is meeting constrained supply, creating upward pressure on prices. The scale of current and potential future policy expenditures suggests that consumer spending may be artificially sustained for an extended period.
The combination of strong demand and constrained supply is a classic recipe for persistent inflation. Yet, the Fed seems overly focused on the supply side while downplaying the role of its policies in fueling demand.
Inflation Is Broadening
While the Fed has pointed to specific categories, such as used cars and airfares, as evidence of transitory inflation, price increases seem to be spreading across the economy.
- Rising Housing Costs: Shelter costs, which make up a significant portion of the Consumer Price Index (CPI), are rising rapidly due to escalating home prices and rents. These increases are unlikely to reverse and will contribute to ongoing inflationary pressures.
- Wage Growth Accelerating: As companies compete for employees in a tight labor market, wages are increasing at the fastest rate in decades. Rising wages often trigger a wage-price spiral, in which businesses transfer labor costs to consumers through higher prices.
- Commodity Prices Surging: Prices for key commodities like lumber, oil, and metals have skyrocketed, driven by strong demand and supply constraints. These increases are raising the costs of goods and services across the board.
The broadening of inflation beyond a few isolated categories suggests it is becoming more entrenched in the economy, challenging the Fed’s transitory narrative.
Inflation Expectations Could Unanchor
One of the most concerning developments is the risk that inflation expectations might become unanchored. If consumers and businesses start to expect higher inflation, they may change their behavior to reinforce it.
- Consumer Expectations on the Rise: Surveys indicate that consumers increasingly anticipate higher inflation in the coming year. This could result in heightened wage demands and greater spending, which might further drive inflation.
- Businesses Raising Prices: Many businesses are already indicating their plans to raise prices to counteract increasing input costs. This creates a feedback loop in which price hikes lead to further price hikes.
- Market-Based Measures: Inflation expectations derived from financial markets, such as breakeven inflation rates, have risen significantly, indicating that investors expect higher inflation in the medium term. If inflation expectations become unanchored, the Fed could lose control of the narrative, making it much harder to bring inflation back to target without causing significant economic pain.
The Risks of Delaying Rate Hikes
By maintaining its transitory inflation narrative and delaying policy tightening, the Fed risks a scenario where inflation spirals out of control, forcing it to act more aggressively later.
- Catching Up Is Painful: If the Fed delays raising interest rates or tapering asset purchases too long, it might have to tighten policy suddenly, which could cause a swift slowdown in economic growth or even trigger a recession.
- Credibility at Stake: The Fed’s credibility is at stake. If inflation continues to rise and the public loses confidence in the Fed’s ability to control it, restoring that trust will be difficult and expensive.
- Global Implications: As the world’s central bank, the Fed’s policies have global repercussions. A delay in addressing inflation could lead to financial instability in emerging markets and worsen global inflationary pressures.
Conclusion: A Call for Prudent Action
The Fed’s narrative of transitory inflation appears increasingly misaligned with the reality on the ground. Supply chain disruptions may not be temporary, and policy stimulus seems to drive demand as inflation spreads throughout the economy.
The Fed should recognize the ongoing inflationary pressures and establish a path toward gradually normalizing monetary policy. This involves tapering asset purchases, indicating future rate hikes, and informing the public about a change in policy stance.
Waiting for “more data” or expecting inflation to resolve itself miraculously is a risky gamble that could have severe consequences for the U.S. economy. The dangers of inaction may exceed the dangers of premature action.