The Fed Is Way Behind the Curve

Excerpt from March 15, 2022 Morning Briefing

The Fed is woefully behind the inflation curve. The CPI inflation rate was 7.9% y/y during February. The last time it was this high was during January 1982 (Fig. 5). Back then, the federal funds rate was 13.2%; today it is near zero, where it has been since March 2020. The spread between the federal funds rate and the CPI inflation rate was -7.8% during February, the most negative it has been on record (Fig. 6).

I doubt that Fed Chair Jerome Powell will do what it takes to bring inflation down as did former Fed Chair Paul Volcker. When Volcker took the helm of the Fed on August 6, 1979, the Great Inflation was well underway. During the summer of 1979, oil prices were soaring because of the second oil crisis, which started at the beginning of the year when the Shah of Iran was overthrown. Seven months later, in March 1980, the CPI inflation rate peaked at its record high of 14.8%. When Volcker left the Fed during August 1987, he had gotten it back down to 4.3%.

How did he do that? He simply stopped pegging the federal funds rate and let it soar to a record high of 19.1% during June 1981. The real federal funds rate, which fell to -4.9% during June 1980, jumped to a record 9.5% during June 1981. The result was a severe recession that caused inflation to tumble.

The Powell-led Fed is likely to gradually tighten monetary policy. Fed officials no longer use the word “transitory” to describe the rebound in inflation since last March. Instead, they acknowledge that it has turned out to be “persistent.” But I don’t expect aggressive moves because I believe that most Fed officials still expect (hope) that inflation will moderate once supply-chain disruptions are fixed and Putin’s War ends (hopefully soon).

During the Q&A segment of Powell’s June 16, 2021 press conference, he was asked whether he believes that inflationary expectations remain anchored around 2%. Powell responded in the affirmative: “So the answer is yes, I think they are anchored and they’re at a good place right now.” In the July 7, 2021 Morning Briefing , I asked, “At what point do rising short-term inflationary expectations become a long-term concern?”

Powell’s colleagues at the Federal Reserve Bank of New York are tracking inflationary expectations closely in their Survey of Consumer Expectations. The data start in June 2013 and are available through February of this year. Over the one-year- and three-years-ahead periods, consumers expect that inflation will be 6.0% and 3.8% (Fig. 7). I wouldn’t call those expectations well anchored given that both measures were around 2.5% just before the pandemic.

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