Fed Watch: Doubt Grows On Fed Inflation Stance Across The Economics Spectrum

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Somebody besides Larry Summers is calling the Federal Reserve’s new plan on inflation “dangerous.” Now it's two British economists.

Writing for OMFIF last week, their analysis of current US central bank policy was headlined, “The Fed’s dangerous experiment.” Tim Congdon, an avowed monetarist, is chairman of the Institute of International Monetary Research at the University of Buckingham, and co-author Juan Castañeda is director. They warn that the “explosion” in money growth heralds a significant rise in inflation .

“But most economists—in universities and central bank research departments—ignore money in their inflation analyses,” the authors say.

“Instead, they use New Keynesian models, where the trend in inflation is driven by inflation expectations and the change in inflation by the output gap.”

The authors trace this approach to a seminal 1999 article co-authored by Richard Clarida, a Columbia University economist who is now vice chairman of the Fed. Following the New Keynesian approach, Clarida is among those who take comfort in subdued inflation expectations as expressed in bond yield differentials and employment below its pre-pandemic peak indicating a negative output gap.

Fed Gospel Still Inflation 'Transitory' But Politics, Economists Weigh

“But the New Keynesians have difficulty explaining the rise in inflation that has already occurred and may be unduly complacent in believing that upward pressures on prices will soon evaporate,” Congdon and Castañeda say.

Fed Chairman Jerome Powell was nonetheless preaching the central bank’s gospel in testimony last week to the House Select Subcommittee on the Coronavirus Crisis. He reiterated the Fed’s stance that recent higher inflation is due to depressed prices a year ago and “transitory supply effects.”

Under questioning, Powell acknowledged that “these effects have been larger than we expected.” A growing number of skeptics are asking what happens if inflation continues to be higher than what policymakers anticipate.

“Our judgement is that U.S. consumer inflation of between 5% and 10% will persist for several quarters,” the British monetarists write. “Further, to return to inflation rates close to 2%, the Fed must cease asset purchases and moderate the annual rate of money growth to 5% or less.”

But such monetary tightening doesn’t seem to be in the cards. For all the Fed’s vaunted independence, Powell and his colleagues on the Federal Open Market Committee are clearly not immune to political influence.

Carolyn Maloney, a senior New York congresswoman, had no compunction last week in warning off the Fed after economic projections showed FOMC members moving up their timeline for interest-rate increases.

“The Fed should be very cautious about pumping the brakes on the economy,” Maloney, a former chair of the Joint Economic Committee, said in an interview with the Financial Times.

“The main point I want to make is that we’re coming out of an economic depression. So the last thing we need is for the Fed to tighten monetary policy too quickly and send us right back into a recession.”

One might question whether projecting a rate increase for 2023 is really a tightening of monetary policy, but politicians seem intent to keep Fed policymakers in line lest they stray from the prevailing conventional wisdom.

New York Fed chief John Williams, the only regional bank chief who is a permanent voting member of the FOMC, last week sought to reassure investors that the message from Washington has been heard.

“It’s clear that the economy is improving at a rapid rate, and the medium-term outlook is very good,” Williams said during a virtual event for the Midsize Bank Coalition of America. “But the data and conditions have not progressed enough for the FOMC to shift its monetary policy stance of strong support for the economic recovery.”

But a New York University economist famous for his gloomy forecasts, Nouriel Roubini, is much less sanguine. The Fed’s shift in emphasis to employment and equity, entailing a higher tolerance for inflation, will tie its hands when price pressures turn out to be much more persistent than anticipated, he says.

“We're going to end up with high inflation and a wage-price spiral over time,” Roubini said on Yahoo Finance Live.  

“And the Fed cannot tighten because there is so much debt in the system, if they're going to try to tighten too soon, the system is going to crash. So they are in a debt trap. They're in a fiscal dominance.”

Roubini correctly warned in 2006 that a collapse in housing prices would lead to a prolonged recession, and has made a string of accurate forecasts through his February 2020 warning that markets were too complacent about coronavirus.

This New Keynesian is on the opposite end of the economics spectrum from the British monetarists, but he shares their fear that inflation is back and won’t be going away anytime soon.

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