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WASHINGTON — The recent rise in inflation gives Federal Reserve officials more reason to begin discussing the eventual liquidation of pandemic-driven easy money policies at their meeting next week.
A growing number of economists are becoming concerned that the Federal Reserve may be lagging behind the inflation curve as it seeks to help the labor market recover. If that happens, the central bank will have to tighten policy more abruptly than economists and market participants currently expect, dealing a potential blow to the economy and fueling market volatility.
“The severity of the current inflation and the current bottlenecks in supply chains and labor markets are greater than I expected,” former Fed Vice Chairman Donald Kohn said, adding that he still shared the central bank’s belief that the inflation recovery is temporary. But it is also possible that the underlying balance between supply and demand will not correct as easily or comfortably as the Fed and I previously predicted. It made the inflation antenna shudder.”
The first step in what is expected to be a gradual process of cutting easy money will be to slow the Fed’s purchases of mortgages and government bonds, something Fed Chair Jerome Powell said he is in no hurry to do.
The Labor Department said Thursday that consumer prices rose 5% in May from a year earlier. So-called core prices, which exclude volatile food and energy components, rose 3.8%, the largest annual jump since 1992. That followed strong price increases in April as well. The Fed is aiming for 2% inflation over the medium term, although it is using a different indicator as a measure.
Central bankers note that the recent increase in inflation has been driven by an unusual combination of pent-up supply and demand bottlenecks from consumers moving out of their homes — pressures that should ease on their own later this year.
But Thursday’s data raises the stakes for the Federal Reserve as it begins to influence a rollback of stimulus policies introduced early in the pandemic.
Since last year, the Fed has kept its key overnight interest rate near zero and has been buying at least $120 billion a month in Treasuries and mortgages. Its goal is to support the recovery of the economy by providing cheap credit.
Economists say easy money is likely to exacerbate some of the imbalances that drive up prices, as it feeds demand without directly boosting the supply of workers, cars or airline tickets. A major risk is that price increases become large or sustained enough that consumers and businesses begin to expect and accept higher inflation. If that happens, the Fed is more likely to raise interest rates than it currently expects to lower those expectations.
For decades, the Federal Reserve has relied on inflation expectations to guide its monetary policy, realizing that interest rate increases or cuts can take months or years to wind down the economy. If the outlook shows hyperinflation on the horizon, the Fed has tightened its policy to prevent inflation from rising that far.
But last August, after more than a decade of sub-target inflation, the Fed scrapped that strategy for a strategy that prioritizes a strong labor market. Under the new strategy, if the economy is below full employment, the Fed will wait until it sees evidence of inflation remaining above target before tightening policy.
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Fed officials have said since December that they will not raise interest rates until the labor market returns to maximum employment and inflation has risen to 2% and is on course to rise moderately for some time.
They haven’t said how much they’ll be comfortable letting inflation go or for how long, but the sheer scale of the recent price increases suggests it’s on track to meet or exceed the Fed’s target sooner than expected just a few months ago.
Central bankers warned in their recent statements that they will act sooner if inflation becomes a problem.
Julia Coronado, a former Fed economist and president of MacroPolicy Perspectives LLC, said she doesn’t think recent inflation data calls for the Fed to change course.
At the Wall Street Journal’s CEO Board summit, Janet Yellen expressed confidence that the US economy and employment will return to normal by next year.
“These price pressures focus very narrowly on things that look like they are clearly going to be transient,” Ms Coronado said. “Think about this: We are in our sharpest moment. It won’t get any sharper than this. We are reopening. We are directing stimulus to the economy with a fire hose. We have maximum stimulus monetary policy.”
Mark Carney, a veteran central banker who led the Bank of England from 2013 to 2020 and the Bank of Canada from 2008 to 2013, said he sees mounting evidence that the malaise in the US labor market and related price pressures could extend well beyond the short term. .
“The probability that inflation will be above target for a longer period of time than the combination of past overshoot – I think the balance of risk is headed in that direction at this point,” Mr. Carney said at a Brookings Institution event on Monday.
Write to Paul Kiernan at [email protected]
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