The Fed’s focus on average inflation, rather than real-time markers, has weighed on reaction
Central bankers are paying the price for relying too heavily on the rearview mirror. None more so than Federal Reserve Chairman Jerome Powell.
US consumer prices rose 8.5% in the 12 months ending in March, official data showed on Tuesday. It is the largest jump since 1981 and three times greater than a year ago. Inflation may now be at or near its highest point. But prices will continue to rise faster than the Fed’s target for some time, despite the series of interest rate hikes ahead. Powell’s mistake was using an approach that paid too little attention to real-time markers of price pressures.
Cleveland Fed President Loretta Mester said Sunday that inflation will stay above 2% this year and next. Unexpected shocks, such as spikes in energy prices after Russia invaded Ukraine, are partly to blame. But so is the monetary policy framework, called the flexible average inflation target, that Powell unveiled in 2020. This compass was designed to deal with an economy that generated very little inflation, and it failed when prices started rising faster. Its shortcomings meant that Fed officials were slow to raise interest rates and they are catching up.
Powell is almost certain to raise the target federal funds rate by half a percentage point in May, from 0.25% to 0.5%, according to CME Group’s FedWatch tool. And there is a 70% chance that the official interest rate will reach at least 2.5% by the end of 2022.
Although inflation may justify a rapid series of hikes, aggressive tightening carries risks for the economy, as Fed Governor Chris Waller acknowledged on Monday when he said a “brute force tool” such as rate hikes could cause Sometimes collateral damage. Economists polled by Reuters see a one in four chance of a US recession next year, rising to 40% over the next 24 months.
Critics of the Fed’s policy framework pointed out its main flaw up front. Targeting average inflation is a recipe for leaving policy too loose for too long and then having to tighten too quickly. Their peers, such as the Bank of England, were also so focused on low inflation that they were slow to spot new problems. Placing more emphasis on disruptions to labor markets and supply chains, rather than thinking past patterns would reassert themselves, would have helped policymakers do a better job of planning for the future.
