What Powell must do next after admitting that he was wrong about ‘transitory’ inflation

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CAMBRIDGE, UNITED KINGDOM – It took a long time, but key Federal Reserve officials have finally admitted that for months they have misjudged inflationary growth that has proven to be bigger and more persistent than they expected.

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That recognition is welcome, especially given the possibility that inflation will remain uncomfortably high in the coming months. The challenge now, not only for the Fed but more broadly for the United States and other major economies, is navigating a policy terrain in which communication and implementation have been radically more complex. misinterpretation as inflationmoment partner,

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The initial characterization of inflation earlier this year was understandable. From March to May, in particular, strong base effects were at work, as inflation in the year-ago period was suppressed by the lockdown of the global economy in response to COVID-19. In addition, policymakers expected markets to resolve the initial mismatch between increasingly strong demand and short supply as the economy continued to open up.

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Federal Reserve Chairman Jerome Powell discussed in a Senate review the factors that continue to drive inflation and the risks of the Omicron variant to the economy. Photo: El Drago/Businesshala News

long term inflationary pressures

By the summer, it was clear to some of us that such temporary factors were happening with long term issues, The firms were detailing the persistent nature of disruptions in their supply chains. Labor shortages were multiplying, adding to the cost-push drivers of inflation. Few, if any, companies were hopeful that both of these issues would be resolved soon — and said so on a one-on-one earnings call.

But, instead of revisiting its initial inflation call in light of the figures, the Fed doubled down. The momentary meaning lasted from a few months to a few quarters, with some commentators and executives even embracing concepts “Extended Fleeting,” “Persistent Fleeting,” and “Rolling Temporary.” In the process, he lost sight of the analysis of a fleeting event.

Some transients are widely believed to be temporary and quickly reversible. As such, economic agents—whether consumers, producers, or wage earners—see no reason to change their behavior. Instead, theyLook” accident.

Even core inflation – which offset volatile food and energy prices – has risen over the past year with no end in sight.

market inspection

But by the end of the summer, it became Obvious That behavior on the ground was changing, especially as inflation continued its steady climb (6.2% in October for the headline consumer-price index and 4.1% for the main personal-consumption spending price index, the Fed’s preferred gauge). Nevertheless, in line with the classic behavioral trap, the Fed stuck to a tentative concept with chair Jerome Powell re-emphasize In the last week of November that “inflation will come down significantly in the next year.”

unrealistic expectations

Many rightly note that the Fed does not have the tools to unblock supply chains or increase labor-force participation. But if the Fed persisted with this fleeting inflationary mindset even longer, it risks uncovering another strong driver of future price increases — that of unchecked inflation expectations. And while that would not mean a return to the double-digit rates of inflation of the 1970s, it would result in a significantly higher persistence of inflation rates that are securely wired to the economy and financial markets.

The later the Fed is responding properly to inflationary developments, the more likely it is that – by pushing the policy brakes hard – it will become the main cause of the temporary inflation pattern, on which it unfortunately had its share of credibility. But if proven correct as such, the Fed would risk a damaging domestic recession, market volatility and destabilizing spillovers for the global economy.

Such a pattern is familiar to economic historians. Stuck behind the inflation curve, the Fed suddenly scrambles to tighten monetary policy, hitting demand hard and pulling the rug out of firms that seek to increase prices and keep them high. Many workers lose their jobs, robbed of labor’s bargaining power. And markets go through periods of destabilizing volatility, risking adverse spillbacks to an already struggling economy.

This risk scenario is particularly worrisome for the more vulnerable sections of the population. Having to deal with already high prices that affect a large portion of their weekly budget, they will also face the risk of unemployment and income loss. In addition to unnecessary damage to economic well-being, there will be negative socio-political and institutional impacts as well.

It is therefore encouraging that, on the last day of November, Powell suddenly made a U-turn on inflation and said it was time”retire“Transient characterization.

The Fed must now swiftly follow-up by doing two things. First, as part of an urgent effort to gain the credibility needed for its forward policy guidance and operational independence, it should publicly detail why its inflation calls went wrong and prevent similar slippages in the future. What is being done to avoid Second, the Fed must move very quickly in reducing its monthly asset purchases. Easing its foot from a stimulus policy accelerator that is still essentially in “pedal to the metal” mode will help mitigate the risk that the Fed will have to slam a policy brake inadvertently in mid-2022 .

Mohamed A. El-Arian, president of Queens College, University of Cambridge, is a professor at the Wharton School at the University of Pennsylvania, and author of “The Only Game in Town: Central Banks, Instability, and Avoiding the Next Collapse”. Random House, 2016.

This comment was published with permission Project Syndicate , Can the Fed Overcome Its Momentary Policy Mistake?

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