The Fed's Historic Error
The US Federal Reserve’s series of suboptimal decisions in the last 12 months regarding inflation means that its next policy decision also is likely to be suboptimal. Rather than being able to deliver a smooth landing for the US economy, the Fed must now judge what constitutes the least harmful option.
CAMBRIDGE – A close friend who has been incredibly successful in his tech career once observed that an initial suboptimal decision is likely to lead to a series of subsequent bad decisions. Economists call this “multiple equilibria.” And the US Federal Reserve, the world’s most influential monetary institution, finds itself in the midst of such a situation regarding inflation – with implications that extend well beyond US economics and finance.
The initial phase of the Fed’s ongoing inflation mistake – an error that will likely be remembered as one of its biggest ever – started with last year’s protracted mischaracterization and dismissal of price increases as “transitory.” Although evidence of persistently high inflation dynamics was increasingly visible, the Fed repeatedly dismissed these signs, failing, most notably, to heed the warnings expressed by firms on one earnings call after another.
It is not entirely clear what was behind the Fed’s initial misstep on inflation. What remains baffling is that, for most of 2021, policymakers seemed eager to double down on their “transitory” claim, rather than show humility as their inflation forecasts were revealed to be repeatedly and spectacularly wrong.