In response to last week’s message from the Federal Reserve chair, Noah Williams and Alex Horenstein, professor and associate professor, respectively, with the University of Miami Patti and Allan Herbert Business School, concurred that the central bank will deliver a steady diet of interest rate hikes and contractive monetary policy to reduce inflation, a necessary stance that will hurt businesses and households.
Fed chair Jerome Powell’s broadcast on Aug. 26 was part of the 2022 Economic Policy Symposium. The annual gathering hosted by the Federal Reserve Bank of Kansas City convenes dozens of central bankers, policymakers, academics, and economists from around the world in Jackson Hole, Wyoming.
In his speech, Powell noted that the U.S. central bank is heeding lessons from the past, specifically the high-inflation decade of the 1970s, and highlighted that the Fed will take “forceful and rapid steps to moderate demand to better align with supply” until it is confident the job is done.
“The historical record cautions strongly against loosening policy prematurely,” Powell stated, noting that the restrictive policies will hurt households and businesses in the short term. “These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
The University economists responded to questions and shared their insights to Powell’s report.
What steps should we anticipate the Fed will take in coming months?
Williams: The Fed has signaled that it will continue to increase interest rates for the foreseeable future in order to bring down inflation. The federal funds rate—the overnight interest rate which is the Fed’s main policy instrument—now stands at about 2.3 percent, up from near zero at the beginning of the year. In their last projections (released in June), the Fed anticipated increasing this rate to 3.8 percent by next year. While there are some signs that inflation has slowed, there have been no real developments which would lead this to a substantial change in the policy plans.
Was the Fed too slow in responding to the increasing inflation?
Horenstein: The government has implemented a very aggressive expansionary fiscal policy throughout the pandemic. The Fed antagonizing the rest of the government might not have been an optimal policy either.
Williams: The Fed was very late in responding to the increases in inflation, which makes its policy problem now much more difficult. Inflation accelerated for nearly a year before the Fed finally recognized that it was not transitory and thus unlikely to recede on its own. Even after making a major policy announcement last November, the Fed waited four more months while its asset purchases wound down before actually increasing interest rates. Simply put, the Fed underestimated the scope, duration, and persistence of the inflation problem.
Powell highlighted that the current high inflation scenario is part of a global phenomenon caused by the pandemic and the war in Ukraine and that countries worldwide are suffering record inflation, some considerably higher than in the United States. What are the implications of U.S. belt-tightening for the rest of the world?
Horenstein: This is correct. External and internal factors have fueled inflation. Externally, we faced a pandemic that brought major disruptions to supply chains and now the Russian invasion of Ukraine, further putting pressure on many commodity prices. Internally, to ameliorate the effects of the pandemic, governments have implemented expansionary fiscal and monetary policies. The combination has put enormous pressure on global prices.
The consequences for the world of the Fed tightening monetary policies are going to be relevant. For example, many emerging countries (and companies) have their debts in dollars, and higher dollar interest rates make it hard to roll over and repay their debts. It also makes it harder to issue new obligations. In addition, higher dollar interest rates make the dollar appreciate, further complicating paying a dollar-denominated debt to emerging economies and companies in those countries.
Williams: Some of the increase in inflation is driven by increases in costs, initially stemming from the supply chain issues during the pandemic, and then this spring and summer there was a spike in food and energy costs following Russia’s invasion of Ukraine. These factors affected all markets around the world. In addition, like the U.S., many countries engaged in fiscal expansion—increasing government spending during the pandemic to varying degrees—which also propped up demand. Thus, many of the factors underlying the inflation increase were similar around the world, although their importance differs.
While some other countries like Canada and the UK have been more aggressive in increasing interest rates, the U.S. responded relatively more quickly than Europe and others. This has led to a run-up in the value of the dollar, which in turn has led to problems in international markets and for countries with dollar-denominated debt or other liabilities.
What can be done to address the public’s expectation of inflation, which in turn has a significant impact on inflation itself?
Horenstein: The only way to avoid inflation becoming ingrained in public expectation is to implement policies to reduce it. If people notice that their dollars are worth less every time they go and buy something, you can do nothing to change their expectations except to avoid the dollar losing value.
Williams: The best course of action is to have a stable, predictable policy response that the public can credibly believe. The Fed gained a lot of credibility in the Volcker (1979-1987) and Greenspan (1987-2006) eras, where the public could trust that policymakers would deliver on their promises. The Fed lost credibility last year when it kept reiterating (or hoping) that inflation was transitory and would recede on its own. It is now trying to regain that credibility.
In addition, underlying all of this is the fiscal situation: increases in unfunded liabilities and expansion of the government debt put pressure on the Fed to keep interest rates low. Increased interest rates lead to increased debt costs, requiring either higher future taxes or higher future inflation to deflate the debt cost. After the pandemic budget blowout, returning to a more normal fiscal situation is critical to keep future inflation stable and the overall economy on a positive trajectory.
What is your biggest takeaway from Powell’s message?
Horenstein: Interest rates are going to keep increasing until inflation is tamed.
Williams: After a long delay, Powell is trying to convince markets and the broader public that the Federal Reserve will do “whatever it takes” to rein in the inflation problem in the U.S. While some had forecast that the Fed would soon cut interest rates again to prop up the economy, the chair made it clear that such a policy pivot is not likely anytime soon.
