Prices keep rising in
America, and policymakers are asking how the central
bank could let this happen. Forward guidance I think
overall slowed the response of the Fed to the inflation
problem last year. Investors think more price
increases are coming. By the Fed's count of
inflation expectations, prices will have risen an
additional 6.8% by the summer of 2023. It turns out that the
Federal Reserve might hold some of the blame. It is going to be very
challenging. It has been made
significantly more challenging by the events
of the last few months. We need to make sure that
the central bank is on the side of everybody in the
country. The big concern is that not
only will we have these big increases in inflation this
year, but that will lead people to expect higher
increases in the future. Because if that's the case,
it sort of compounds upon itself. We could be headed to
stagflation. Might get better, but it might get a
whole lot worse. And if it gets a whole lot
worse, brace yourself for uncertainty. How did the U.S. government
misread inflation and what does this mean for people
in the United States? The Federal Reserve is
America's central bank. The job of the Federal
Reserve is to safeguard the buying power of the dollar
and to make interest rate policy in the public
interest. They're supposed to
minimize inflation, maximize employment. It does this by working with
retail banks that Americans use. Think Chase, Bank of
America, Wells Fargo, etc.. Banks have an account at the
Fed the way you have an account at a bank, and the
Fed takes that money and invests it in Treasury
bills, mortgage backed securities, and pays the
bank a little bit of interest. The Fed manages the U.S. money supply. Their
decisions can have a large economic impact, but some
believe that Congress's actions within the economy
are much more important. The Federal Reserve needs to
be reformed. The Federal Reserve needs
individuals who are on the receiving end of monetary
policy, not individuals who are only PhDs in economics,
who've never held a job in the real world and have a
penchant for life and are not affected by zero
interest rate policy making life more difficult for for
savers who don't have a public pension for life. The Fed's job is
complicated. It involves making predictions about
the future, things like, How much will inflation be a
year from today? And if it's up, what should
we do about that? Experts believe the U.S. central bank has made
important decisions that drove better outcomes
throughout history. Supporters point to the
Fed's strong provisions of credit during the 2020
recession. This cash ultimately kept
millions of people afloat as the world locked down. Also, the bank achieved a
balance of low inflation, cheap lending rates and low
unemployment for the better part of three decades. This stability minimized
price increases while supporting the creation of
many jobs. But occasionally mistakes
are made. The forward guidance, I
think overall on the margin slowed the response of the
Fed to the inflation problem last year to some extent. So does that mean it was a
mistake? I think in retrospect, yes, it was a
mistake and I think they agree it was a mistake. So here are the three big
mistakes. The first was a sharp
increase in the money supply. In recent years,
the overall pot of cash in the Fed's control has grown
sharply. Changes in the money supply
can take months or even years to materialize within
the economy. If the same amount of goods
existed in the economy, but there was twice as much
money, then we would think that the price of
everything would double. This sharp increase
initially showed up in the savings accounts of regular
Americans before they quickly vanished. Well, from everything that
we've seen, that money is concentrated in the hands
of the oldest and the wealthiest Americans. What has stuck around is a
fierce upward spiral in prices for goods. As this dynamic took hold,
the Fed kept adding dollars to the money supply,
primarily by printing and issuing bonds that some say
the market didn't need. The result was the sharpest
bout of inflation observed in more than four decades
in the States. Similar dynamics unfolded
around the world, bringing forth a historic new
inflationary era. Very few households, if you
will, ever got to enjoy the benefits of zero interest
rate policy. Only your biggest
borrowers. Now on to mistake number
two. When it started to raise
interest rates, the bank was doing so at way too slow of
a pace. The Central Bank uses its
federal funds interest rate to counteract this high
level of inflation. Their models suggest that
if this interest rate goes up, that will make
inflation go down. That's exactly what they're
trying to do now. The Central Bank waited
until March 2022 to flip the switch and make lending
more expensive. They started with quarter
percentage rate hikes and have since made bigger
hikes. This fast pace of lift off is a start of a
sharp reversal from the past three decades of policy. So the Federal Reserve
maintaining record low interest rates for a long
period of time sort of led to some of the largest
asset bubbles that we ever saw. And people who had
money sort of going into the crisis and were able to
deploy that capital into the stock market, into the
housing market, have done extraordinarily well as a
result of the Fed's policies. The final mistake here was
that the Fed waited too long to act at all. Early signs of inflation
took hold for months before the Fed took action. For example, fuel was up
more than 50% in November of 2021. Even prices for used
cars were up over 30% year over year in the same time
frame. This was happening as the
Fed kept its interest rates near zero and kept buying
massive amounts of bonds. At the time, the bank
called inflation transitory, hoping it would pass. So far it hasn't. As Chair Powell indicated
himself, both of us probably could have used a better
term than transitory. But the Federal Reserve
wasn't the only group that made mistakes during this
time. Economists believe that the
federal government played a very large role in this
inflationary spiral too. Fiscal policy is made by the
Congress and the president, and that involves taxation
and spending. And that's different from
monetary policy because it really affects the amount
of money that is going to be in your pocket, whereas
monetary policy works through the banking system. So some of the record
fiscal stimulus that we saw coming out of the COVID
recession were expanded unemployment insurance
checks, the general checks, the enhanced child tax
credit. All of those were examples
of fiscal policy to try to get the economy recovered
as quickly as possible. Economists like the famous
Milton Friedman believed that inflation comes from
changes in the money supply. Most of the episodes Milton
Friedman looked at were times when governments
which were in deep problems printed money and handed it
out. So if you remember nothing
from this, remember one thing: if you print money
and hand it out, drop it from helicopters, as
Friedman said, you will get inflation. The current Federal Reserve
Board keeps track of the supply in a publicly
available data set. See the sharp uptick in
2020? This money went directly
into the hands of actual people who spent it, saved
it or invested the funds. That creates a fierce rush
of demand. And, at the time, it was
outpacing supply of the goods available, possibly
creating inflation. A lot of that money went
into emergency COVID bills like the American Rescue
Plan. The government was able to spend cash it
didn't have because it got huge loans from the Fed. And printing money to spend
it, printing money to hand it out, printing money to
make transfer payments, that's exactly what our
government did in the last two years of the pandemic. It's technically not
printing money, but it's, from an economic point of
view, the same as printing out money and handing it
out. And it causes inflation. So that is both monetary
and fiscal policy. The next time there's a
handout, don't be so easy to take it. Just bear in mind
what got us here. And that was overly
intrusive and aggressive fiscal policy that was
monetized by the Federal Reserve. Outside of its own missteps,
the government's fight with inflation was accelerated
by various things outside of their control. Economists
call these events black swans. In the 2020s, these
so far have included: COVID. Supply chain
disruptions. Full scale invasion by
Russia into Ukraine. But when the U.S. government
needs someone to respond to these events, they turn to
their Federal Reserve and whatever the Fed decides to
do will then reverberate worldwide. That's because
many businesses settle transactions with U.S. dollars, which the Fed
controls. So there is a massive
transmission mechanism that transmits U.S. monetary policy to the rest
of the world. 80 some odd percent of all
transactions in the world are done using the U.S. dollar and Fed policy
influences and dictates where the U.S. dollar is. So whatever we do is not
contained within the United States economy. It affects the global
economy. Dealing with these
unexpected shocks is quite difficult as the Fed wades
through other unknowns. As inflation took hold,
some voting seats at the Fed stayed open. And making
matters worse, a key member was forced to resign in
what some believe was an insider trading scandal. Other voting members like
Michelle Bowman warned of the danger of excess
inflation, but went unheard in the committee chambers. The Federal Reserve Board is
a massive organization full of staff who need to know
who's my leader going to be. And Randy Quarles said
publicly, had there not been that level of internal
uncertainty and strife, that the Fed would have been
raising rates last year when it knew policy had become
problematic, especially as it pertains to the housing
market, which is the only form of inflation right now
that is in the Fed's control and it looks like
they're trying very hard to break. Given that's the situation,
it seems like the Fed's decision to continue to
prop up the market was misguided because that sort
of added fuel to the inflationary fire that
we're currently dealing with. Economists believe that the
Fed now has less ability to get things back on track
without sparking a recession. It's still
possible, though. To do that, they'll need to
rapidly increase lending rates to what economists
call a neutral interest rate, one where the economy
is neither growing or shrinking too quickly. The neutral rate is a real
interest rate. It doesn't matter if the
neutral rate is 3%, that means something very
different if inflation is 8% versus if inflation is 2%. If inflation is going to be
high and remain higher, that means that the neutral rate
in the economy is also going to be higher. Because the
price of goods are going up, we need a higher return
to stabilize the economy. If we were actually
measuring inflation in a consistent manner, the
peaks in the seventies and eighties are actually much
more similar to the peak today than we would have
initially thought. Still, the stories of the
past could be relevant material for today's class
of central bankers. While the mistakes are far
and few between, they can have a profound impact. And for the record, their
good calls can make a big impact too. If they hold steady and are
committed to breaking inflation, as was the case
with Paul Volcker, then we'll get to the end of
this situation of pain quicker than if they were
to try and draw out, postpone, delay the
inevitable. So I think at this point
the Fed has to stick to its guns, even if that means
taking speculators down. And that really is what has
scared the Fed in the past. The Federal Reserve is
supposed to make monetary policy in the whole of the
public's interest, not just that of investors. And this is going to be a
test of which they have not really had to take since
1981.
