Jerome Powell Is Fighting Inflation — and Winning

Comment

When Federal Reserve Chair Jay Powell speaks in Jackson Hole later this week, he will have no shortage of critics lying in wait to vivisect his every remark. Their nearly universal theme is that the Fed has done too little, too late to stem rising inflation. Powell, the argument goes, bought into the misguided view that 2021’s inflation would be transitory.

As a result, the Fed continued pressing on the gas when it should have been hitting the brakes, keeping interest rates at zero through 2021. To make up for those mistakes, Powell will have to convince the public that he’s abandoning the Fed’s policy framework and admit that he is prepared to deliver the pain.

The truth is far more sanguine. Yes, Powell does need to strike a solid, credibly anti-inflation tone. But the Fed has been fighting inflation since March — in both word and, more important, deed. And the effort seems to be paying off.

The Chicago Fed’s Adjusted Index of Financial Conditions, for example, measures how difficult it is for consumers and businesses to get loans. A reading below zero represents relatively easy conditions; above zero means they are relatively difficult.

Since the Great Recession, the index has been above zero only three times: first, in the aftermath of the debt ceiling crisis of summer 2011; second, during the first few months of the Covid lockdowns of 2020; and last June. That was just after Powell announced that the Fed would increase interest rates by 75 basis points and said he would raise them for as long as it would take to bring down inflation.

The Fed made good on that promise by raising rates by another 75 basis points in July. After that meeting Powell made it clear that there was no tradeoff between inflation and employment, because a stable labor market could not be guaranteed unless action were taken to stabilize prices.

The folksy common-sense nature of that remark might obscure just how hawkish it is. Ever since the Great Depression, mainstream economists have seen the Fed’s role as trying to balance the competing concerns of low unemployment and low inflation.

Powell’s position is that whatever rise in unemployment is necessary to bring inflation down to 2% is worth absorbing in the short term, because it provides long-term labor market stability. From the point of view of statistical economics, that’s not strictly true. It’s entirely possible for a country to accept double-digit inflation rates as the “price” of rapid growth.

From the point of view of US political economy, however, it’s exactly right. There is approximately zero chance that the US political system would accept inflation rates as high as they are now year after year without doing something drastic, and maybe even foolishly destructive.

Still, some economists say Powell hasn’t been nearly strident enough. Former Treasury Secretary Larry Summers, for one, has seized on Powell’s statement that the Fed had nearly reached neutral levels of interest rates. Summers’s logic — that with core inflation at 4% to 5%, interest rates would need to be at least that high to bring “real” after-inflation rates down up to zero — makes superficial sense but is belied by market data.

The US government sells inflation-protected bonds that compensate the buyer for actual inflation over their term. The five-year inflation-protected interest rate rose from -1.6% at the end of last year to 0.3% in August. Like the financial conditions index, that represents significant tightening.

Some bond experts see recently falling yields in the broader fixed-income markets as evidence that investors are questioning Powell’s resolve. But the more plausible explanation is that bonds are rallying because the situation in Europe is deteriorating so rapidly. That’s likely to put downward continued pressure on commodity prices and ease inflation in the US. Inflation-adjusted bond yields have remained strong.

After Powell’s adoption of the transitory inflation hypothesis at last year’s Jackson Hole retreat, bashing him now is the path of least resistance. But his critics are fighting the last war. Powell’s words and actions since the beginning of this year have been right on target.

Jerome Powell Is Fighting Inflation — and Winning

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