Can the Fed Overcome Its Transitory Policy Mistake?
The later the US Federal Reserve is in reacting properly to inflationary developments, the greater the likelihood that it will have to hit the policy brakes hard, causing market turmoil and unnecessary economic pain. The Fed must now do two things quickly.
CAMBRIDGE – It took way too long, but key officials at the US Federal Reserve have finally acknowledged that for months they mischaracterized an inflationary surge that has proven larger and more persistent than they expected. That recognition is welcome, especially given the likelihood that inflation will remain uncomfortably high in the coming months. The challenge now, not just for the Fed but also more broadly for the United States and other major economies, is to navigate a policy terrain in which communication and implementation have been rendered significantly more complex by a fundamental misreading of inflation as “transitory.”
That initial characterization of inflation earlier this year was understandable. From March to May, in particular, strong base effects were at work, because inflation in the year-earlier period had been suppressed by the lockdown of the global economy in response to COVID-19. In addition, policymakers hoped that markets would quickly resolve the initial mismatch between robust demand and lagging supply as the economy continued to open up.
By summer, it was clear to some of us that such transitory factors were being accompanied by longer-term issues. Firms were detailing the persistent nature of the disruptions in their supply chains. Labor shortages were multiplying, adding to the cost-push drivers of inflation. Few, if any, companies expected these two issues to be resolved any time soon – and said so on one earnings call after another.