Today’s inflation numbers are yet another reminder of the inflation denial in which the Federal Reserve is currently engaging. More troublingly yet, those numbers have to raise serious questions as to whether, by being overly sanguine about inflation, the Fed will leave it too late to engineer a soft economic landing next year.
At a time that the Fed’s inflation target is 2 percent, it now emerges that over the past year the Fed’s favorite inflation index, the Personal Consumption Expenditure Deflator, increased by 3.9 percent. This was the highest level reached since 2008, when oil prices were at approximately twice today’s level.
Perhaps of greater concern yet is the fact that even stripping out food and energy prices from the Fed’s favorite inflation yardstick, over the past year core PCE inflation increased by 3.4 percent. This was its fastest pace in the past thirty years. It also must be cause for considerable concern that over the past three months, core PCE inflation has been running at an annualized rate in excess of 6 percent.
To be sure, the Fed has now grudgingly raised its 2021 inflation target from the 1.8 percent that it had expected at the start of the year to 3.4 percent. However, despite the fact that inflation has greatly surprised the Fed on the upside, the Fed still insists that there is no need for it to begin winding down its ultra-easy monetary policy stance to fulfill its inflation mandate.
In the Fed’s view, today’s unanticipated inflationary burst has been largely due to supply-side factors. These include Covid-related disruptions to global supply chains, including most notably those affecting electronic chips so essential to modern industrial production. They also include labor shortages induced by generous supplemental unemployment insurance benefits and school closures that have required parents to be at home with their young children.
The Fed assures us that these supply-side problems will soon be resolved. Once resolved, inflation will come back towards the Fed’s 2 percent inflation target on its own accord without the need for any Fed action.
The fundamental flaw in the Fed’s thinking is that it is turning a blind eye to the strong demand-side forces that are all too much in evidence and that are bound to lead to economic overheating towards yearend. Indeed, never before have we had such a powerful demand-side cocktail consisting of the largest peacetime budget stimulus on record, the easiest monetary policy on record, and the unusually large degree of pent-up household demand that was built up during the Covid-related lockdown of the economy last year. That pent-up demand is bound to be released as America returns to a semblance of post-Covid normality.
In gauging the demand-side inflation risks to the economy, all one needs to do is to look at the very size of the budget stimulus. At a time that the Congressional Budget Office estimates that there is only a 3 percent difference between the current level of economic activity and that which the economy could achieve at full employment, the economy is receiving budget stimulus of the order of 12 percent of GDP. That by itself must be expected to lead soon to economic overheating.
If there is one thing that we know about monetary policy, it is that it operates with long and variable lags. This makes today’s Fed inflation denial all the more regrettable. By the time the Fed gets around to dialing back its currently ultra-easy monetary policy stance, the inflation genie is all too likely to be well out of the bottle.
Desmond Lachman is a senior 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.