Powell Should Target Long Rates To Fight Inflation

With purchases of Treasury and mortgage-backed securities ending and an increase in the federal funds rate expected this month, Chair Jerome Powell takes aim at inflation.

Unlike former Chairs Alan Greenspan and Janet Yellen, he panicked stock and bond markets by failing to anticipate inflation and clearly communicate a path for rate increases — other than through the speculations of members of the Fed policymaking committee and the closely watched Fed dot plot.

Apparently, he is seeking a soft landing — to somehow recapture 2% inflation without significantly slowing economic activity. That’s virtually impossible.

Supply chain disruptions, chip shortages, consumers with flush bank accounts from too much stimulus spending, environmental policies that curb fossil fuel investments before EVs and renewables are adequately available, knock-on effects of high energy prices on groceries, and skill mismatches in labor markets are together creating an inflationary perfect storm the likes of which have not challenged Fed chairs since Paul Volcker.

Pay is booming for technology-related jobs, bankers and less-skilled workers in short supply often owing to child care shortages. But overall, wages aren’t keeping up with inflation.

Winding down the economy a bit won’t change those dynamics enough. As workers return to offices, restaurant prices, car prices and rents closer to employment centers will get another jolt. Add a new variant of COVID-19 or escalated war in Ukraine and all bets are off.

Since the 1950s, inflationary pressures this serious have only been quelled by a significant economic slowdown—either induced by tight monetary policy or some other disruptive force — but perhaps Treasury Secretary Yellen has Mr. Powell convinced this time will be different.

She is preaching that President Biden’s Build Back Better program will be resurrected, increase labor availability, boost productivity and reduce inequality. Unfortunately, his child care proposal would increase daycare costs by as much as 80% while denying middle-class families access to federal subsidies for several years.

How discouraging work among college graduates earning $50,000 to $100,000 a year in vital services increases the labor supply and dampens inflation is beyond my expensive education in economics.

If Mr. Powell raises interest rates too slowly or too little as is likely — the recent forecasts project about 2 percentage points over the next 20 months — then inflation will persist even as the economic growth slows a bit. Conversely, if he were to follow Volcker’s playbook — he raised rates by 7 percentage points in eight months — the economy will tank.

Contrary to Mr. Powell’s peculiar ideas about stimulative monetary policies, lowering unemployment to 3.9% reduced inflation-adjusted wages for the average worker. And by assisting asset bubbles that favored wealthier Americans, those increased inequality.

A tepid monetary policy to curb inflation will only make worsen these dynamics. Buying into Yellen’s supply-side fairy tale, in hopes that a Democratic majority in Congress will somehow rally, pass critical elements of BBB and rescue him would be a fool’s journey.

During the last two tightening cycles, raising the federal funds rate failed to boost the 10-year Treasury rate or other long rates very much, because foreign money came into U.S. bond markets as U.S. rates attempted to inch up.

With China, Japan and the EU continuing easy money policies, the Fed will have to use its balance sheet to target the 10-year Treasury rate — something it has not done in the past — to soak up foreign capital inflows through aggressive sales of its $8 trillion hoard of Treasury and mortgage-backed securities.

Instead, the Fed has promised to sell to those at a predictable pace and rely primarily on adjustments in the federal funds rate to tighten monetary policy.

Targeting the 10-year Treasury rate to maintain a positively sloped yield curve — the difference between the long and short rates — is essential to cooling the pace of inflation for housing and durable goods and restoring calm to equity markets.

Stock prices are hardly the Fed’s primary concern but creating undue panic in equity markets won’t help it accomplish 2% inflation with minimum job losses.

Over 11 of the 13 Fed tightening cycles since 1954, stock prices saw downdrafts similar to what we are experiencing now but ultimately recovered to post generally significant gains.

Investors closely watch the yield curve and leaving the 10-year Treasury rate to policy choices in Beijing, Tokyo and Brussels is a terrible gamble against that record, but what are we to expect from a Fed chair who told us inflation was transitory for so long after that fanciful dream was patently false.

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