Will The Fed Curb Inflation, Or Will Politics Prevail?
Telegraph (Nashua, NH)
The Consumer Price Index has been increasing at close to a 5 percent annual rate. The Federal Reserve just announced its plans to begin tapering its bond purchases — essentially scaling back an economic stimulus — later this month, but the market is not expecting it to fight inflation by raising interest rates until the middle of next year. Politics will have a role to play in that decision.When the money supply increases faster than the production of goods and services, consumers use the extra dollars to bid up prices. The Fed has committed itself to flexible, average-inflation targeting, meaning it would like to keep inflation around 2 percent over the long run, but can tolerate higher or lower levels in the short run. However, the longer it delays raising interest rates, the harder it will be to hit the target.
According to the M2 indicator, the money supply increased by 35.6 percent between January 2020 and September 2021, with much of it used to pay for expanded government spending. Not surprisingly, we've seen an increase in the rate of inflation.
The Fed controls the money supply by controlling the quantity of bank reserves and by varying the interest rate it pays banks to hold those reserves. Higher rates entice banks to hold more excess reserves, whereas lower rates encourage them to lend and put more money into consumers' hands. Thus, to reduce the rate of money supply growth, the Fed would need to increase interest rates, which would reduce the amount households and businesses borrow.
Here's where things get thornier. Even though the Fed is an independent agency, it is subject to political pressure. President Biden will soon decide whether to reappoint Jerome Powell as its chair, and that decision will depend on whether he expects Powell to manage monetary policy in a way consistent with the administration's goals. And the Biden administration is not shy about its desire to increase government spending on social programs.
Raising interest rates would not be popular, and it would increase the cost of borrowing for the government, businesses and households. Not only would this make it harder for the administration to finance its ambitious spending plans but it would reduce business investment, which could result in reduced hiring. It follows that the Fed faces political pressure to keep expanding the money supply and keep interest rates low, in spite of the inflationary consequences.
There are several other complicating factors:
A number of prominent economists believe that the current high rate of inflation will decline as America's supply chain problems are resolved. However, evidence is beginning to pile up showing that it may continue for at least the next two or three years.
Chairman Powell has indicated a desire to delay interest rate increases in hopes of bringing down the unemployment rate further. But this is a risky policy. If inflation persists and people expect it to remain high, many will spend and invest more rather than hold dollars that slowly lose purchasing power. This will bid up market interest rates and prices, fueling inflation.
And if inflation persists in spite of Fed officials' insistence that it is temporary, it will become harder to convince people that inflation rates will be low in the future — a vital expectation in order to maintain a prosperous economy in the long run.
Finally, if the expectation of prolonged inflation puts upward pressure on interest rates before the Fed acts, it could find itself with no choice but to raise interest rates just to catch up with the market. Because inflation lags behind money supply increases by as long as two years, acting too slowly could mean a steady ratcheting up of inflation, similar to what happened during the 1970s.
If this happens, the only way to bring inflation down could be by raising interest rates rapidly by a large amount. But doing that would interfere much more with businesses' investment plans, and would likely contribute to a severe recession, as it did in the early 1980s.
In promoting its policy of flexible average inflation targeting, Federal Reserve officials sometimes speak as if controlling inflation and inflation expectations is easy. It's not, especially if businesses and consumers lose confidence that the Fed will continue to keep inflation low, as it did between 1991 and 2020.
It succeeded then by preemptively raising interest rates during economic recoveries. To maintain its credibility as we bounce back from the COVID-19 downturn, the Federal Reserve needs to stick with what has worked.
Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University. He wrote this for InsideSources.com.