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The Inflation Tail Is Wagging the Policy Dog

Now that markets have finally been conditioned for interest-rate hikes, the danger of financial over-tightening looms large. Just as central bankers have embarked on a long-overdue process of balance-sheet unwinding, global developments have pushed the economy to the edge of recession.

NEW YORK – With prices in many advanced economies surging, central banks are being roundly criticized for falling “behind the curve” on inflation. But they didn’t. Government policies and geopolitics constrained central bankers from normalizing their monetary policies until inflation was already upon them. Chinese and Russian supply-chain disruptions collided with the synthetic demand created by the US Department of the Treasury mailing free money to American consumers.

There is now very little room for monetary tightening without stalling the economy (which is already faltering under tightening financial conditions). But make no mistake: the window to tighten monetary policy was missed because of decisions made by political leaders. It is they who bear responsibility for fixing the problem, keeping in mind that the longer-term economic environment is still defined by the “three Ds”: rising debt, demographic aging, and disruptive labor- and demand-displacing technologies. In these conditions, persistent disinflation is more dangerous than episodic inflation.

In retrospect, it is clear that the US Federal Reserve and other central banks were forced by political leadership to defer policy normalization (a prerequisite for responding effectively to the next crisis) while the economy was strong in 2018. When the pandemic hit, former President Donald Trump’s administration and Congress panicked, directing the Treasury to borrow trillions of dollars to finance “economic impact payments” to stimulate consumer demand. Then in 2021, Joe Biden’s newly installed administration essentially repeated the process.