The Federal Reserve Keeps Fighting The Last War

By Desmond Lachman of AEI.

"Generals are said to keep fighting the last war. The same might be said of Jerome Powell’s error-prone Federal Reserve.

In 2021, at the very time when the ground was being laid for a surge in inflation to a multi-decade high, the Powell Fed fretted about the prospect that inflation would remain stubbornly low. It even went so far as to say that it would tolerate inflation being above its 2 percent target for some time. Today, when clear signs are emerging that inflation is decelerating, the Powell Fed keeps insisting that it still has more interest hikes to make. It is doing so even after having hiked interest rates over the last year at the fastest pace in four decades.

The Powell Fed’s excessively loose policy response to the 2020 Covid-induced recession is very likely to go down as one of the Fed’s biggest policy errors in the post-war period. At a time when the economy was receiving its largest peacetime budget stimulus on record, the Fed chose to keep interest rates at their zero-bound. It also flooded the market with liquidity by buying $120 billion a month in Treasury bonds and mortgage-backed securities and it allowed the broad money supply to balloon by a staggering 40 percent over a two-year period. Unsurprisingly, except perhaps to the Fed, by June 2022 headline inflation surged to 9.1 percent.

In a belated response to inflation’s surge, it was only in March 2022 that the Fed found monetary policy religion. Over the past year it raised interest rates rapidly by a full 5 percentage points. It also shifted away from a policy of flooding the market with liquidity through its bond buying activities to one of withdrawing $95 billion a month in liquidity by not rolling over its maturing bond holdings. In the process, the Fed has allowed the unusual occurrence of a decline in the broad money supply. In the past, such a decline has often presaged an economic recession.

Although monetary policy is known to work with long and variable lags of between 12 to 18 months, the Fed’s latest round of monetary policy tightening has already produced welcome results on the inflation front. Headline inflation has fallen in each of the last eleven months to its present level of a little over 4 percent. Meanwhile so-called core inflation, which excludes gasoline and food prices, has come down to around 5 percent.

In a recent research report, Goldman Sachs noted that we must expect a number of deflationary forces over the rest of the year to bring core inflation down to 3 ½ percent. Among those factors were falling used car prices, a marked moderation of rent increases, and an improved balance in the labor market.

It is more than likely that Goldman Sachs is understating the further substantial progress to be made in bringing core inflation down in the second half of this year. Banks are now restricting credit as a result of the problems in the regional banks, as exemplified by Silicon Valley Bank’s failure, and of an expected wave of real commercial property defaults. That must be expected to reinforce monetary policy’s effort to restrain domestic demand. At the same time, it would seem that strong deflationary forces will be coming from China. As a result of its struggling economic recovery, which is being hit by the bursting of its property and credit market bubble, China’s producer prices are now falling and its currency is depreciating.

Yet despite these deflationary forces, and despite the likelihood that the full effect of the past year’s tightening is still to be fully felt by the economy, the Fed shows every sign of maintaining its hawkish monetary policy stance. Indeed, in his most recent Congressional testimony, Mr. Powell was at pains to tell Congress that the Fed’s job of reducing inflation was far from done and that two more interest rate hikes were likely in the rest of the year.

The moral of the story is that the Fed keeps making the same policy mistakes. To wit, it follows a backward-looking data dependent policy and it pays too little regard to the long and variable lags with which monetary policy operates. Last year those policy mistakes gave us a bout of high inflation. Over the next year, those same mistakes are likely to give us an economic recession."