Federal Reserve Chair Jerome Powell is trapped in a dilemma that’s essentially guaranteed to keep the central bank at the mercy of inflationary forces, not in control of them. The US Fed’s monetary policy tools are useless against surging global food and energy prices, but they’re starting to play an outsized role in rising inflation expectations — a situation that could embed rising prices in the national psyche.
That’s bad news for the economy and raises the risk of stagflation. In his remarks to reporters on June 15 after the central bank raised interest rates 75 basis points, Powell appeared to acknowledge how powerless he felt. “We can’t really have much of an effect, but we have to be mindful of the potential effects on inflation expectations,” Powell said. “So it’s a very difficult situation to be in.” It’s tricky indeed, and Powell’s commitment to mindfulness won’t help one bit.
When the US Fed raises interest rates, it can be a powerful moderating force for rate-sensitive markets such as automobiles or housing, but it can’t do much about commodities that are traded on global markets. That’s one reason economists and policy makers tend to focus on ‘core inflation’, which strips out those volatile components.
The problem is that food and energy are also important factors in the way the public actually experiences inflation, and can help fuel the perception that prices are out of control. People buy bread and gas repeatedly, and they’re more likely to notice when those prices go up as opposed to the cost of a computer or a dishwasher that they may purchase only once every few years. As Powell put it on June 15:
Headline inflation is what people experience. They don’t know what core is. Why would they? They have no reason to. So expectations are very much at risk due to high headline inflation.
Once consumers believe inflation is getting away from policy-makers, they may demand raises, which companies will deliver by raising the cost of manufactured goods even more — the dreaded wage-price spiral. As Powell put it on June 15, the US Fed is “absolutely determined” to keep inflation expectations anchored, and he said the increase in those expectations to the highest since 2008 — as measured by the University of Michigan’s survey of consumers — played a significant role in the central bank’s decision to raise interest rates by 75 basis points for the first time since 1994.
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If the US Fed only adjusts its path after inflation expectations have already increased, the central bank will always be on its heels. The alternative is to react each time energy prices rise, assuming they’ll pass through to expectations, and risk causing a recession for naught. Basically, the reaction function Powell has described suggests he’s just hoping to minimise the damage while praying that he gets lucky with the factors that are out of his control.
Clearly, the US Fed’s challenge wouldn’t be as daunting if it had been more aggressive last year when inflation was already on the rise. Inflation expectations are where they are because the public has now lived with rising prices for some time as the US Fed mostly stood by and watched. Some of that initial inflation was beyond the central bank’s control, too, but there was plenty it could have prevented. Now policy-makers are at the mercy of commodity markets, and the US Fed is essentially doomed to stay behind the curve.
Jonathan Levin has worked as a Bloomberg journalist in Latin America and the US, covering finance, markets and M&A. Views are personal, and do not represent the stand of this publication.
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