Americans pay a price for Federal Reserve's procrastination

Investors, homebuyers and others needing credit hang to news about inflation and employment, looking for cues about when the Federal Reserve will start lowering interest rates.

It’s difficult to anticipate the Fed’s next move because it has not effectively articulated its challenges.

Monetary policy has long lags, which change from one business cycle to another depending on fiscal policy, structural challenges in the private economy, external shocks that instigate recessions or inflation and how quickly the Fed responds.

The federal government’s structural deficit has increased.

The economy recovered from the global financial crisis of 2007-2009, reaching full employment in 2016, and the federal deficit was 3.1% of gross domestic product. Fully recovered from the worst of the COVID-19 pandemic, the Congressional Budget Office projects the deficit this year will be 6.7%.

That’s a big jump in fiscal stimulus and requires higher interest rates to keep inflation in check. Those won’t necessarily curb growth owing to the boost to demand from additional fiscal stimulus.

Larger deficits, however, place more demands on capital markets. With the national debt zooming past 100% of GDP, bond investors will require higher interest rates to offset the risks that Washington might inflate its way from under its large debt service burden.

Artificial intelligence and policies to reduce carbon emissions — switching to electric vehicles, climate control for buildings and cooking and wind and solar for generation — require substantial new capital.

Consequently, many economists believe that real R*, the inflation-adjusted rate of interest that neither slows the economy nor causes inflation to accelerate, is higher now than in the decade before COVID-19. A good estimate is 2%, or the real potential rate of growth in the economy.

Inflation, though improved, remains significantly elevated.

The consumer price index was 3.3% higher in May than a year earlier.

We are not building homes at the pace we did before the financial crisis, owing to limited supplies of buildable land near metropolitan employment centers. Homebuyers understand a shortage and are bidding up prices at a 7% annual pace despite high mortgage rates.

Rents on apartments and estimated for owner-occupied homes are 36% of the CPI and advancing at a 5.4% annual pace. Core services less housing are 25% of the index and popping along at 5.2%.

When inflation started heating up in the spring of 2021, the Fed procrastinated.

Chairman Jerome Powell and the Biden administration told us inflation was temporary. The Fed delayed raising interest rates for a year and then did so slowly.

President Biden proclaimed that Milton Friedman wasn’t making policy anymore. At the height of the pandemic, the Fed printed enough money to purchase $4.8 trillion in Treasury, mortgage-backed and other securities.

The Fed has never expressed genuine culpability for how much that ultimately juiced consumer spending and inflation when the COVID-19 shutdowns ended.

Mr. Powell keeps telling us inflation expectations are well anchored — those are, but not at 2%.

The household surveys conducted by the Conference Board, the New York Federal Reserve and the University of Michigan put the expected inflation rate at 3% to 4%.

Inflation has been elevated for so long that workers, when they bargain for wages; homebuyers, when they weigh mortgage rates against anticipated appreciation; and consumers, when they consider whether they can bargain on prices, no longer believe they live in an era of price stability comparable to the 2010s.

Households have lost confidence that the Federal Reserve can further tame inflation and that the current cast of policymakers will really do what it takes.

That would put nominal R*, the observed interest rate that would neither slow the economy nor accelerate inflation, at 5% to 6%.

Currently, the target federal funds rate is 5.375%. It would seem that if anything, that interest rates should stay where they are or be raised to bring down observed and expected inflation.

Fed policymakers project the long-term federal funds rate to be about half that — 2.8%.

Simply put, Fed policymakers appear to have lost touch with reality.

The economy should now slow down because most consumers' capacity to absorb higher prices is flagging as the extra savings accumulated during the pandemic have finally run out.

High-income households, with large wealth positions in stocks and fixed income investments, have enjoyed surges in nonwage income. For most others, however, downward adjustments in spending are needed as their capacity to pile up debt is more limited than the U.S. Treasury.

Past battles with inflation would indicate that inflation would accelerate again if the Fed lowered rates before reaching its 2% goal.

That would cause inflation expectations to rise and harden further. The situation would devolve into a cycle of tightening to curb inflation, then loosening to boost employment with inflation ratcheting up, as during the decade before then-Fed Chairman Paul Volcker was forced to take draconian steps to curb the Great Inflation.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.