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Opinion: The Fed should hike rates now to stop inflation instead of relying on it to cut the balance sheet to get the job done

NEW HAVEN, Connecticut (Project Syndicate) – The U.S. temporary inflation debate is over. The rise in US inflation has gotten far worse than the Federal Reserve expected. The constantly optimistic financial markets largely accept this. It is widely believed that the Fed has both the wisdom and the firepower to keep underlying inflation in check. That remains to be seen.

For its part, the Fed advises patience. She is so convinced that her poor prognosis will eventually turn out to be correct that she is content to wait. No surprise: the Fed telegr -hed such a reaction with the “Average Inflation Targeting” framework adopted in summer 2020. In doing so, the Fed signaled that it was ready to forgive inflation above target in order to compensate for years below – target inflation. She didn’t know what she was getting into.

With inflationary pressures moving from temporary to ubiquitous, policy rates should be the first line of defense, not the last step to cut.

Looking backwards is not possible

In theory, an average inflation target seemed to make sense – an elegant arithmetic consistency of underflows that are offset by overruns. In practice, it was flawed from the start. It was an inherently backward-looking  -proach, heavily conditioned by a long history of slow growth and low inflation.

The Fed, like many others, believed that the early 2020 pandemic shock was cut from the same wood as the 2008-09 global financial crisis, underscoring the possibility of another anemic, disinflationary recovery that could dangerously propel already low inflation towards deflation.

Just like J -an. Since the dot-com bubble COMP, + 0.74%, burst in 2000, the Fed’s political decision-makers have been concerned about a J -anese endgame for a crisis-prone US economy – decades of economic stagnation paired with ongoing deflation. These concerns are understandable when a crisis hits while inflation is already dangerously close to zero. However, by fixating on the risks of J -anese-style deflation, the Fed ignored the possibility of a major inflation surprise.

And that’s exactly what h -pened. Thanks to an explosive recovery in aggregate demand after the lockdown, which the Fed itself played a major role in boosting, already strained global supply chains quickly coll -sed. From food, semiconductors and energy to shipping, households and wages, today’s price and cost pressures are far too numerous to count. Temporary one-off price adjustments have been ubiquitous, and now a major inflation shock looms.

Balance miracle

But there is an additional complication – the Fed’s belief in the magical power of its balance sheet. Like the average inflation target, quantitative easing stems from the recent crises. Ben Bernanke, first as Fed governor then as chairman, led the task of cataloging the endless list of unconventional policy options available to a fiat monetary system when the nominal rate  -proaches zero.

Bernanke first put this in the form of a thought exercise in 2002, emphasizing the Fed’s unlimited c -acity to inject liquidity by buying assets should deflation risks rise. But when reality got close to the hypothetical in 2009, Bernanke’s script turned into a plan of action – as was the case once again in the depths of the 2020 COVID-19 shock, it never had the ammunition.

The challenge lies in normalization – restoring monetary policy to pre-crisis levels. And the Fed has yet to figure this out for both the conventional base rate and the unconventional balance sheet.


The Fed faces two complications in normalizing monetary policy.

First, the lifting of ultra-accommodative monetary policy is a delicate operation that increases the possibility of corrections in the investment markets SPX, + 0.76% DJIA, + 0.69% and in the wealth-dependent real economy. Second, there is confusion over the timeframe for normalization – how long it will take to get politics back to pre-crisis settings. That’s because, until now, there has never been an urgency to normalize. The persistence of low and often below target inflation would leave an inflation-oriented central bank a lot of leeway to gradually and gradually find its way along the path to normalization.

Think again Now the Fed has to normalize in the face of an inflation shock. This calls into question the glacier process envisaged in a low inflation normalization scenario. The Fed did not make this important distinction. It has telegr -hed a mechanistic execution of the two-step  -proach it used in the depths of the crisis. The Fed sees normalization as simply an operation in reverse – first curbing its balance sheet and then raising interest rates.

While this order might be  -propriate in a low inflation environment, inflation shock makes it impractical. The preferred first step, balance sheet adjustments, is likely to have limited effects on the real economy and inflation. Balance sheet transmission channels that span long-term interest rates and delayed wealth effects through asset price adjustments are, at best, very cumbersome.

Reevaluate the sequencing

The Fed needs to rethink its mechanistic  -proach to monetary policy sequencing.

With inflationary pressures moving from temporary to ubiquitous, policy rates should be the first line of defense, not the last step to cut. In real terms (adjusted for inflation) the Federal Funds Rate is FF00, -0.00%,
currently at -6%, is deeper in negative territory than the lows in the mid-1970s (-5% in February 1975), when monetary policy mistakes set the stage for the Great Inflation. Today’s Fed is woefully behind the curve.

My advice to the Federal Reserve Open Markets Committee: It’s time to encourage creative thinking. When inflation rises, stop defending a bad forecast and forget tinkering with the balance sheet. Get on with the heavy hikes in interest rates before it’s too late.

Independent central bankers can afford to ignore the foreseeable political backlash. I just wish the rest of us could do the same.

Stephen S. Roach, a faculty member at Yale University and past chairman of Morgan Stanley Asia, is the author of Unbalanced: The co-dependency of America and China.

This comment was courtesy of Project Syndicate – The Fed needs to be creative again

More views on inflation

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