Fed Policy Versus Demand & Supply-Shocks

The US economy is currently facing a major energy shock, and the Federal Reserve needs to apply strategies designed for supply shocks. Yet, the Federal Reserve appears to be operating under the belief that they are still dealing with the long-term impacts of a demand shock. The projections from the March 17-18 Federal Open Market Committee meeting suggest a long-term forecast of official rates at 3% and inflation at 2%, resulting in a real official interest rate of 1%. In today's world, that projected rate is much too low.

Although demand and supply shocks may share characteristics like job losses and wealth destruction, the primary distinction lies in their impact on inflation.

Demand shocks generally result in a significant drop in inflation, whereas supply shocks have the opposite impact, leading to price hikes from production through to distribution and retail, which in turn causes both headline consumer inflation and core inflation to rise.

Prior to the two demand shocks of the early 2000s (the tech bubble and financial crisis), the Fed maintained a real longer-run official rate of 2%, sometimes reaching as high as 3%. Following the demand shocks, particularly the financial crisis, the Fed maintained very low and even negative real official rates, after factoring in the stimulative impacts of the quantitative easing policy.

However, those economic conditions are now a thing of the past. Currently, with core inflaiton at 3% and managing with a nominal official rate in the low mid-3% range during the initial phases of an energy shock places monetary policy in a precarious situation, as it increases the risk of prolonged higher inflation. Policymakers aim to avoid the policy errors made after the COVID supply shock, but the political climate might leave them with no alternative.

Therefore, it should come as no surprise that the bond market is sensing more inflation.