Why Did Inflation Surge To A 40-Year High? Here Are 4 Causes Of The Worst Monetary-Policy Mistake In Years
Why Did Inflation Surge To A 40-Year High? Here Are 4 Causes Of The Worst Monetary-Policy Mistake In Years.
The MarketWatch 50 Published: Nov. 1, 2022 By Greg RobbFollow
‘I don’t think I would do that again’: Jay Powell grapples with how the Fed got inflation so wrong and lands on the MarketWatch 50 list of the most influential people in markets
How Federal Reserve Board Chairman Jay Powell is ultimately remembered will depend on whether he’s able to tame inflation without driving the U.S. into a deep recession. GETTY IMAGES
The Federal Reserve has made two major policy blunders in the last 25 years.
The first was being unaware that the foundation of the U.S. banking system had been eroded away by complex mortgage securities that carried high credit ratings but turned out to be toxic during a broad housing downturn. The resulting meltdown in valuations caused the global financial crisis in 2008 that hobbled the U.S. economy for years.
More recently, a misreading of the strength of the labor market and the persistence of price shocks sparked by the pandemic led to the highest inflation rate in 40 years and the final chapter of this saga is still to be written. The policy error paved the way to make 2022 the worst year in financial markets arguably since the 1930s. Both stocks and bonds have plummeted and Federal Reserve Chairman Jerome “Jay” Powell is at the center of the financial turmoil, landing him on the MarketWatch 50 list of the most influential people in markets.
Critics have pounced on the Fed. Powell’s insistence that rising inflation was “transitory” and would quickly dissipate once the economy reopened more fully has been called “probably the worst inflation call in Fed history” by Mohamed El-Erian, chief economic adviser for Allianz.
The economist Stephen Roach has compared Powell to former Fed chair Arthur Burns, whose indecisiveness under intense political pressure led to the crushing inflation of the 1970s. As recently as March 2022, when the Labor Department was reporting a 7.9% annual rise in consumer prices, Powell and the Fed were just wrapping up their injections of liquidity into financial markets.
How Powell, who is not a trained economist, is ultimately remembered will depend on whether he’s able to tame inflation without driving the U.S. into a deep recession. It could still all end relatively well, but the debate about what signs the U.S. central bank ignored and why will be studied and debated for years to come.
For now, outside experts are debating the causes that led to the big policy mistake. Some Fed officials, including Powell, have started to chime in. Following are the four underlying causes of the initial policy error that emerged in interviews with experts. They include the Fed’s new policy framework, Powell’s distrust of forecasts, unintended consequences of some forward guidance the Fed gave markets in 2020, and the nature of the pandemic’s perfect economic storm.
A New Policy Framework Unveiled In August 2020
In August 2020, as the nation was emerging from COVID-19 lockdowns, Jay Powell’s Federal Reserve announced a monumental shift. For more than a year prior to the pandemic, the Fed had been working on a new policy framework and the pandemic wasn’t about to stop the U.S. central bank from implementing what it had been putting together.
“The economy is always evolving,” Powell said. The Fed interest-rate committee’s “strategy for achieving its goals must adapt to meet the new challenges that arise.”
Powell was not referring to the extraordinary economic events associated with the early days of the pandemic. Instead, the policy shift had been designed for a world of low inflation, a reality that had dragged on for some two decades.
“The framework document came after 20 years of it being very difficult to get inflation to 2%. And so, unfortunately, the framework assumed that type of environment was going to persist,” said former Boston Fed president Eric Rosengren, in an interview.
With the new playbook, the Fed essentially decided it would not raise interest rates at the first sign of a strong labor market, which had become a cardinal rule after the the bout with high inflation in the 1980s. Instead, the Fed would be more patient before using the blunt tool of raising interest rates to increase borrowing costs for businesses and consumers to tamp down inflation
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