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The Federal Reserve Won’t Admit It Has an Inflation Problem

America's Inflation Problem
Image: Creative Commons.

The Federal Reserve’s repeated denial that the country might soon have a real inflation problem reminds me of the apocryphal story about the inquest into the sinking of the Titanic. When asked at the inquest why he did not steer the ship away from the iceberg, the captain asked “What iceberg?”.

Today’s worse than expected inflation numbers suggest that the US economic ship might now be on course to hit an inflationary iceberg. It is not just that over the past twelve consumer prices have now increased by 5 percent or at their fastest pace since 2008. Nor is it only that core inflation, inflation excluding volatile food and energy prices, is now running at close to double the Fed’s 2 percent inflation target and is at its highest level since 1991. It is also that inflation appears to be accelerating as indicated by the monthly inflation rate now running at an annualized pace of close to 8 percent.

Yet despite the worse than expected inflation numbers, and despite mounting evidence of labor shortages and wage pressures, the Fed clings to its belief that the inflation we are now seeing will be but a transitory phenomenon.

 In the Fed’s view, the Covid-related supply chain problems that we are now experiencing, especially in computer chips so vital to modern manufacturing production, will soon be resolved. Similarly, the Fed believes that today’s labor shortages will dissipate once schools are reopened and once the generous supplemental unemployment insurance benefits come to an end in September.

Surprisingly, in subscribing to its sanguine inflation view, the Fed chooses to turn a blind eye to the major underlying forces driving today’s inflationary process.

Not only does the Fed choose to ignore the fact that the US economy will be receiving a record peacetime budget stimulus of some 12 percent of GDP in 2021, at a time that the Congressional Budget Office estimates that the current level of US output is only some 3 percent below its full-employment potential level. The Fed also chooses to ignore the fact that its own policies remain highly expansionary and that, as a result of the Covid lockdowns, US consumers have excess savings amounting to around $ 2 trillion. If households now begin to fear that prices are rising, they must be expected to spend those savings and thereby heighten the chances that the economy will soon overheat.

With inflation pressures now rising, the correct thing for the Fed to be doing would be to dial back its currently highly accommodative monetary policy stance to reduce demand pressures. It could start by tapering its present bond-buying activity which continues at a $120 billion monthly pace. It could also begin to prepare the markets for future interest rate increases.

Unfortunately, the prospects for the Fed acting decisively anytime soon do not appear to be promising. Not only does the Fed continue to be in inflation denial. It also has painted itself into a policy box that makes early decisive action very difficult for itself. The Fed has done so by committing itself to not changing policy until it sees actual evidence of sustained inflationary pressure. It has also done so by committing itself to acquiesce to inflation at a rate above its 2 percent inflation target for some time to make up for the many years in which inflation ran at levels below its inflation target.

It is said that those who cannot remember the past are condemned to repeat it. This would seem to be the case of the Fed, which somehow seems to have forgotten the country’s painful inflation experienced in the 1970s. That in turn makes it all too likely that today’s inflationary experience will prove to be anything but transitory.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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Desmond Lachman joined AEI after serving as a managing director and chief emerging market economic strategist at Salomon Smith Barney. He previously served as deputy director in the International Monetary Fund’s (IMF) Policy Development and Review Department and was active in staff formulation of IMF policies. Mr. Lachman has written extensively on the global economic crisis, the U.S. housing market bust, the U.S. dollar, and the strains in the euro area. At AEI, Mr. Lachman is focused on the global macroeconomy, global currency issues, and multilateral lending agencies.