Persistent Inflation and the Federal Reserve

Monetary policy and fiscal policy are two macroeconmic tools used to manage a country's economic activity. And both have great influence over businesses, consumers, workers, and the economy at large. To keep monetary policy separate from fiscal policy, the United States Congress has established the Federal Reserve (the Fed) - U.S. Central Bank - as an "independent agency" to make monetary decisions "based on the best available evidence and analysis, without taking politics into consideration". The US Congress, however, set the goals for the Fed: "maximum employment, price stability, and moderate long-term interest rates". The first two are referred to as the Fed's "dual mandate".

How is the Fed doing in maintaining price stability?

To maintain "price stability", the Fed set a goal of 2% average annual inflation rate for the long term, and has used several tools at its disposal, including the Fed funds rate (the key short-term interest rate), to achieve the stated goal. However, inflation - increases in the prices of goods and services - has been persistent since the COVID-19 pandemic, in part because of supply and demand imbalances, and expansionary policy pursued by both the US government and the Federal Reserve. This "persistent inflation", meaning inflation that is higher than the 2% target rate, has been a major concern for consumers, particularly low-income families and those living on a fixed income.

At first, the Fed was hesitant to act because it believed that inflation would have been transitory, hoping that inflation rate would drop without any monetary policy intervention. As prices continued to rise, the Fed eventually realized that inflation was "sticky", i.e. increases in prices on certain consumer goods are long lasting. Concerned about these sustained increases in prices, the U.S. Central Bank has raised the key short-term interest rate several times but with limited success. (It is worth mentioning that, besides costs of goods, inflation can also impact employment, wages, housing, and production).

What to do to alleviate the pain inflicted by sustained elevated prices?

First, it is important to note that there is no simple answer to this crucial question because the economy remains resilient despite the Fed's moves to raise the key interest rate in order to increase borrowing costs and reduce inflation. "Sticky" prices are resistant to immediate downward changes. As consumers are well aware of, prices go up more easily than they come down. That is why most policymakers usually favor "prevention", whenever possible.

Soft Landing or Hard Landing?

Bringing inflation down is a responsibility that the Fed takes seriously because, as previously mentioned, it is one of its "dual mandate". In its attempt to fulfill this mandate, it has raised the interest rate several times in order to slow the economy. As the funds rate is a potent tool, the Fed has been using it sparingly in order to not cause a hard landing ( a recession that follows a period of excess demand and inflation). The Fed instead would like to guide the economy to what is called a soft landing - bringing inflation back near the 2% target rate without causing a deep economic downturn, which would lead to a deeper global economic crisis. But navigating between a soft landing and a hard landing is a very delicate act to perform.

Some analysts, on the other hand, argue that persistent economic shocks require a stronger and more sustained monetary policy response. They believe that a recession will put an end to the prevailing persistent inflation more quickly. To that end, they would like the Fed to use monetary policy more "aggressively". They further believe that a recession might become an "inevitable" outcome. These views are valid, but they raise at least two questions. First, although the Federal Reserve is allowed to set monetary policy "without political influence", would it be inclined to force a hard landing in an incoming presidential election year? Second, is recession more desirable than inflation?

Fiscal-Monetary Policy Cooperation

The economic shocks engendered by the COVID-19 pandemic had forced fiscal and monetary authorities to synchronize their policies in order to mitigate the impact of a protracted and severe economic crisis. Those coordinated policies were largely effective, but they contributed to the advent of the existing inflation. Therefore, this coordination of policies should continue in order to bring "sticky" inflation under control.

Although fiscal policy and monetary policy are two independent tools to manage the economy, divergent fiscal policy, particularly high levels of government spending, would further complicate the task of restoring price stability and keeping inflation near the 2% target rate.

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