I found it revealing to listen to what Patrick Harker, the president of the Philadelphia Fed, said on CNBC yesterday. Sara Eisen asked him why inflation is so much higher now than he had forecasted last year. His answer? "We all missed some signals...we thought supply-chain constraints would be eased sooner than they are."
Hmmm. It's true that supply chain problems have persisted far longer than expected. But (a) they are not the primary cause of the inflation we are experiencing--Fed policy is; and (b), they are in part a symptom of the Fed's overly stimulative monetary policy. It would be like a Fed official saying "Well, the labor market has been much tighter than expected," without acknowledging that the tightness itself is a result of Fed policy.
And while Harker is blaming the supply chain for the recent overshoot of inflation, the San Francisco Fed put out a letter this week attributing the "direct fiscal support" introduced by the U.S. government in response to the pandemic as the primary reason our inflation has been higher than that of other countries. Their argument is basically that the stimulus checks caused our overshoot, "Contributing about 3 percentage points of the rise in U.S. inflation through the end of 2021."
But what about the even higher inflation we are experiencing now, in 2022? While supply chain issues and fiscal stimulus have contributed to it, they are not the primary drivers of it, especially this year; Fed policy is. Obviously, the Fed itself is not keen to admit this. It would be refreshing to hear that from as plainspoken a Fed chair as Jerome Powell. It's worth noting, however, that his chairmanship is still technically in limbo as he and other Fed nominees await confirmation from Congress (especially after Sarah Bloom Raskin's withdrawal). Making it, in other words, not an ideal time to talk about the errors this Fed has committed.
"It is the central bank that decides whether or not to accommodate fiscal expansion," wrote MKM strategist Michael Darda yesterday. The Fed could have shrunk its balance sheet by 50% last year and jacked rates up to 10%, he notes, if they felt fiscal policy was overly stimulative. They could even have taken baby steps in that direction--but instead, they were running QE ("quantitative easing") at full blast with zero interest rates.
"If fiscal policy was the key source of inflation, inflation expectations would not have risen to all-time highs THIS YEAR as fiscal policy becomes even more of a 'headwind'," Darda wrote. "If fiscal policy was the key source of inflation, inflation rates should have already collapsed last year as the fiscal balance began to turn from tailwind to headwind." Beyond that, "if fiscal policy dominated on the demand side, the 1970s would never have happened," he added, given that fiscal deficits were lower on average that decade than in the 1980s and early '90s.
No, this inflationary overshoot is the Fed's doing, Darda argues. The massive expansion of their balance sheet--which was several times larger than their response to the financial crisis--and their failure to start tightening more quickly are the primary reasons we are seeing inflation continue to shoot higher as nominal demand runs way hotter than trend. Even the supply chain is in part a supply disruption story, but also a story of demand outrunning supply.
Nominal GDP--which includes both real GDP and inflation--soared by more than 10% last year, and is expected to "slow" to a still red-hot 7% to 8% this year, Darda notes. Broad money growth is still running at a 7.5% annualized pace, per his metrics. (The narrower "M2" measure of the money supply is up 11% from a year ago, which would be the most since the early 1980s if not for the even sharper spikes we saw earlier in the pandemic.)
This is why inflation may continue to "overshoot" for quite some time. The economy is running too hot, and that is not the fault of the supply chain, obviously, or even of fiscal policy in the 2020-21 timeframe, which the Fed could have started to "lean against" earlier on. And this is why the market's expected inflation rate over the next five years has shot up this year to 3.4%, from less than 2.9% at the end of 2021.
As hawkish as the Fed has already gotten this month, policymakers may have to get even more hawkish still. And it's not because inflation "happened" to them, but because they are causing it.
See you at 1 p.m!
Kelly
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