Wednesday, November 30

The Fed’s adaptation to reality

The upward trend of inflation in the United States, which has reached levels not seen in almost forty years, has forced the Federal Reserve Bank of that country (Fed) to modify its vision of the seriousness of the risks it faces in order to fulfill its mandate of maximum employment and price stability.

The change seems to have been forced by the extraordinary forecast errors around inflation. Like private forecasters, members of the Federal Open Market Committee (FOMC) have systematically and noticeably underestimated the rise in prices.

The indicator preferred by this central bank to monitor inflation is the Personal Consumption Expenditure Index (PCE). At the December 2020 FOMC meeting, none of the seventeen participants estimated that annual inflation in December 2021, according to the PCE, would exceed 2.4 percent, and the median of the corresponding projections was 1.8 percent.

The FOMC estimates were gradually adjusted upwards throughout 2021. For example, the median forecast went from 2.4 percent in March to 4.2 percent in September.

Although the figure for December 2021 is not yet known, inflation in November, according to the PCE, reached 5.7 percent annually, the highest since July 1982. In addition, inflation, according to the Consumer Price Index, usable indicator for international comparisons, continued to rise until registering 7.0 percent annually that month, the highest rate since June 1982.

Thus, it is likely that inflation in December 2021, according to the PCE, will exceed that of November. With this, it would exceed, by more than one and a half percentage points, the median of the FOMC’s expectations, expressed just three months before the end of that year.

Behind the forecast errors on inflation, there is an incomplete diagnosis of the causes that have originated it. In successive monetary policy communications, from April to November 2021, the FOMC reiterated that the increase in inflation was mainly due to “transitory” factors.

This ambiguous characterization seemed to convey the idea that inflation would soon and on its own return to its previous moderate levels. The elements alluded to by Fed President Jerome Powell in his press conferences included “comparison base effects,” derived from calculating annual inflation with respect to the months at the start of the pandemic, which recorded falls in the price level .

To the above arithmetical consideration, applicable mainly to March and April, reasons were added describing a “supply shock,” associated with disruptions in global supply chains. It was anticipated that, as production operations and product delivery normalized, inflation would subside.

Supply shocks can exert “one-time” pressures on the general level of prices, but they are unlikely to generate continuous and rising inflation. The only way high inflation can be prolonged is for aggregate demand to grow faster than supply.

At the end of 2021, the Fed seems to have begun an acknowledgment, albeit a partial and indirect one, of this factor. In its November and December communications, the FOMC pointed out the existence of “imbalances” between supply and demand, although it associated the latter with spending that had been contained by the pandemic.

In addition, Powell referred to the strong aggregate demand, “encouraged” by the support of fiscal and monetary policy, although he did not relate this reality to inflation.

In any case, the abandonment of the description of inflation as a temporary phenomenon and the acceptance, albeit limited, of demand pressures as a cause, have coincided with the start and subsequent acceleration of the program to reduce purchases of financial assets by of the Fed, whose recent completion date was mid-March 2022.

Hopefully, in today’s monetary policy decision, the Fed will send strong signals about the measures it plans to take to combat inflation. It has been decades since this central bank acted reactively, and not preventively, in relation to this phenomenon.

The advantage is that today, more than ever, this central bank has enough tools to prevent inflation from taking hold. You can increase your benchmark interest rate and you can significantly reduce the size of your balance. Has experience in using future guides. But, mainly, it has a history of credibility that must be strengthened.

Former deputy governor of the Bank of Mexico and author of Mexican Economy for the Disenchanted (FCE 2006)