The Fed is Mistaken: It's the Removal of Inflation That is Destabilizing, Not Late Policy Moves
The Fed is mistaken. The removal of inflation has the most significant destabilizing effect on the economy, not the abrupt change in monetary policy that comes late to dampen or reverse the price cycle and imbalances. Inflation cycles create liquidity, income, and wealth, and its reversal triggers a sharp loss in all of them.
Over the past 50 years, inflation cycles have been broad and narrow, rotating from general consumer and producer inflation to financial and tangible assets. Each has unique features, but each has a common lousy outcome (recession).
The challenge for the Fed nowadays is that inflation is everywhere and in everything ("The Everything Inflation Cycle" Blog of November 26, 2021). Several years ago, I developed a proprietary broad price index consisting of consumer and producer prices and real estate and equity prices. Based on data through January 2022, the broad price index shows a record double-digit increase over the past year, consisting of CPI and PPI gains equal to that of the 1970s and asset inflation that is roughly equal to the dot.com and housing bubbles combined.
In a recent interview Ms. Mary Daly, President of the San Francisco Federal Reserve Bank, stated, "history tells us with Fed policy, that abrupt and aggressive action can actually have a destabilizing effect on the very growth and price stability we're trying to achieve." That is true if the Fed waits until actual inflation worsens before taking countermeasures. The Fed is still easing policy.
The question now does the Fed engineer a Greenspan-type soft landing (1995) or a Volcker hard-landing? Odds favor a Volcker ending.
Look at the evidence.
The 1970s: Supply shocks triggered a sharp rise in consumer and producer prices that fed into wages and expectations. Consumer price inflation averaged nearly 7% per year during the decade, the highest of any decade in the postwar period. Still, policymakers feared the negative trade-off between fighting inflation and increasing joblessness, so policy remained loose. It took a dramatic rise in official rates to kill the cycle, led by Fed Chair Volcker. The result was three years of recession from 1980-to 82.
The 1980s: A sharp rise in cyclical inflation surfaced in the late 1980s following the sharp depreciation of the US dollar and the abrupt easing of monetary policy after the stock market crash of 1987. Consumer price inflation jumped to 6% by the late 1980s. Policymakers lifted official rates to near 10% to break the price cycle. An economic recession and a banking crisis (linked to the collapse in commercial real estate) occurred in the early 1990s.
The 1990s: Against a backdrop of modest consumer price inflation, a surge in asset prices occurred from the mid-1990s to 2000. During that period, the S&P 500 rose roughly 25% per year for five consecutive years, while the Nasdaq posted annual gains of nearly 60%. The surge in equities prices lifted share prices far beyond the company's earnings, creating a unbalance or a bubble. Equity prices fell hard once the Fed reversed its easy money policy. A mild recession occurred in 2001, and equity markets corrected for the next three years.
The 2000s: As the Fed maintained an easy money policy to cushion the economy from the plunge in equity prices, a new inflation cycle started in real estate. According to the S&P/Cass Shiller National House Price Index, housing inflation ran roughly 10% per year from 2001 to 2006, or four to five times the rise in general inflation. The housing bubble ended when once monetary policy and credit conditions tightened. The collapse in house prices triggered the most severe economic and financial downturn in the post-war period.
2021 and ?. The current inflation cycle is unlike anything seen before. The 1970s and 1980s inflation cycles centered on consumer and producer prices, while assets prices (equities and real estate) powered the 1990s and 2000s inflation cycles. Today's inflation cycle has all of the above. And based on the broad price index, the current inflation cycle is as big as the 1970s and the dot.com and the housing bubble combined. (Note: CPI less shelter has risen 9.1%in the last year, the biggest increase since 1981. Including a market-price shelter, the component lifts CPI to double-digits. The old producer prices for finished goods are up 12.5, while core intermediate and crude prices have increased by 23% and 13.5%, respectively. The CPI and PPI account for 85% of the broad price index,)
Policymakers have misread the full scope of the inflation cycle and need to play catch-up. Monetary policy is a blunt instrument, and so trying to attack one or two segments of the inflation cycle will hit them all, but not equally.
History says the odds of achieving a soft landing in the economy is low. Mr. Greenspan successfully landed the economy in 1995, but he raised official rates 300 basis points over twelve months and raised the real federal funds rate from zero to 3%. The current generation of policymakers needs to do as much or more soon or risk doing much more later. Even if policymakers act soon and big, the scale and breadth of the inflation cycle still favor a Volcker-type ending.
One key takeaway from all this is that the analytical framework used to assess the appropriate monetary policy stance has been too narrow and inflexible. A broad price index would be a helpful addition to the Fed's toolbox as it helps distinguish between relative and absolute price movements and provide a signaling effect of significant and persistent increases.