The author is the Paul A Volcker senior fellow for international economics at the Council on Foreign Relations
Of all America’s great institutions, few have flourished in the teeth of adversity like the Federal Reserve. The rickety US electoral system, the violent police, the polarised media, the over-mighty tech companies — all come in for justified censure. But the Fed has navigated financial crises, Trumpian assaults and the pandemic. It has emerged with inflation tolerably stable, its independence uncompromised and the dollar secure in its status as the world’s reserve currency.
This is the background against which to assess the Fed’s next challenge: the danger of an inflation resurgence. After a quarter of a century in which core inflation, excluding volatile food and energy, has tended to undershoot the Fed’s 2 per cent target, prices now threaten to rise faster than desired. If the Fed allows this to get out of hand — and the rate accelerates into the 3 to 4 per cent range — the fallout could be globally disruptive.
The central bank, playing catch-up, would have to jack up the cost of borrowing. Financial markets would tumble. Leveraged companies would go bankrupt. A strong greenback would hammer emerging economies that have debts denominated in dollars and earnings in something else.
The chatter about inflation began six months ago and has grown steadily louder. Donald Trump’s $900bn December stimulus has been amplified by Biden’s $1.9tn March package, with talk of two audacious spending bills to come. Meanwhile, in the private sector the high personal savings rate — a red flag, because it could portend a whoosh of future spending — has continued to climb. Before the pandemic, it hovered just over 7 per cent. Last December it was 13.5 per cent. In the first quarter of this year, it averaged 20.5 per cent. Millions of newly vaccinated Americans are sitting on a mountain of dry powder that could set the economy alight.
What’s more, changes elsewhere have damaged the firebreaks. The pandemic has driven some businesses under, compromising the economy’s ability to satisfy surging demand. Trade tensions have blunted globalisation’s ability to damp prices. President Joe Biden’s Buy America injunctions, his encouragement of trade unions and his drive to improve conditions for gig workers could all push costs up. Meanwhile, the pandemic has transformed consumer habits. Until businesses adjust, inflationary bottlenecks may result.
At this point, doves will object that unemployment remains elevated, so employers can easily scale up production to meet additional demand. But available workers are not necessarily in the right places or sectors. The Philadelphia Fed reports that 45 per cent of manufacturing companies have vacancies that have gone unfilled for three months or more. According to iCIMS, a recruitment agency, job openings were up 22 per cent in the first quarter, but applications were down 23 per cent.
In sum, an inflation breakout is not inevitable — the slight rise in unemployment reported on Friday supports the doves’ argument on labour-market slack. But the risks are significant. A lot hangs on whether the Fed is ready to react firmly if prices do surge. And this brings us to the second part of the inflation discussion. The Fed’s critics advance three reasons why it may lack the fortitude to respond.
First, the Fed has muddied its commitment to its inflation target. To balance past inflation undershoots, it now wants to overshoot the 2 per cent mark for an unspecified period. Since monetary policy works with a lag, this wait-and-see attitude could mean that rate rises come too late to damp price increases before they develop momentum.
If inflation accelerates past 3 per cent, you might expect the Fed to respond fast. After all, the past two decades of low inflation have seldom involved missing the 2 per cent target by more than a percentage point. But the critics’ second concern is that the Fed may judge an inflation surge to be temporary — a blip that will correct once workers shift into new sectors and companies adjust. If this is wrong, inflation will have space to entrench itself further.
This leads to the third, most basic worry. Despite the misleading precision of their forecasts, central bankers make decisions under uncertainty, and they are inevitably political. Their independence exists not in ivory-tower isolation, but in a schedule of congressional appearances, meetings with administration officials and a willingness, notwithstanding, to decide that higher interest rates are sometimes warranted despite the short-term cost. An army of professional Fed-watchers loves to speculate that central bankers lack the spine to make this judgment. Some even whisper that Fed chair Jay Powell, a Republican, may err on the side of easy money to secure his reappointment by a Democratic president.
It’s an enduring parlour game because neither side can know the answer in advance. The enthusiasm for cryptocurrencies testifies to the suspicion that the Fed will let inflation rip. But the last time the sceptics were proved right was in the 1970s, and the cautionary tale of that decade is seared into the memory of every central banker. Perhaps, half a century later, we should embrace the possibility that certain American institutions really are dependable. The past, at least sometimes, can serve as guide to the future. An inflation surge seems all too likely. A supine Fed does not.