The following table shows the record dating back to the start of 2020. It shows the year-over-year growth of the consumer price index, the best-known measure of inflation, alongside that of the personal consumption expenditure price index excluding food and energy. , the Fed’s favorite inflation tracker. It also shows the five-year breakeven inflation rate, a widely used indicator of expected inflation over the next five years, derived from the difference between the yield of plain vanilla and protected five-year treasury bills. against inflation. And finally, it shows the federal funds rate, the Fed’s main tool for fighting inflation, and the yield on two-year Treasury bills.
First, and hopefully least controversial, is to acknowledge that the Fed was right to intervene when Covid-19 crippled the US economy in the spring of 2020. The one-year CPI on the another fell to zero and almost went into deflation. The Fed bailout – aided by a strong fiscal stimulus – stabilized inflation, the economy and markets.
Despite record amounts of stimulus, the Fed struggled to bring inflation to its 2% target over the next year. That changed abruptly in March 2021 when the CPI rose 2.6% year-on-year and the PCE rose 2%. (I’ll focus on the CPI rather than the PCE, since excluding food and energy overlooks much of the inflation people have been experiencing.) Although I imagine the Fed was relieved to see inflation return to more normal levels it would have been hasty to declare victory based on a single month of data so it made sense to wait and see if March was an outlier or the start of a larger trend.
It turned out that prices continued to rise until the spring of 2021, although it was not yet clear that higher inflation would persist. Historically, there have been many bouts of high inflation that lasted for a few months and then receded. Also, higher inflation figures were expected in the spring and early summer of 2021, as prices had been beaten the previous year. Supply shortages and wild swings in consumer spending — not to mention that no one had ever tried to shut down and restart the economy — also made it hard to tell whether higher inflation had truly taken hold. The market clearly didn’t think so as the breakeven five-year rate was pegged at around 2.5% from March to September 2021, slightly above the Fed’s target.
In October, inflation entered a new phase. The year-over-year CPI started to climb to more worrying levels and inflation expectations rose slightly. Critics say the Fed sat idly by at the time, but that’s a misreading of the record. While it’s true that the Fed waited several more months to raise the fed funds rate, it didn’t need to raise rates to have an immediate impact.
The federal funds rate is an overnight lending rate between banks, but its power lies in its ability to move short-term interest rates, which influence the entire economy. Central bankers began signaling their intention to fight inflation in the fall of 2021, prompting an anticipated rise in short-term interest rates. The two-year Treasury yield began to rise significantly in October 2021 for the first time in many years and has risen every month since. Eventually, the Fed had to raise the fed funds rate to maintain credibility, which it began to do in March. Markets obviously find the Fed credible as the yield on two-year Treasury bonds is up 3% from just 0.4% last October.
It is too early to assess the impact of the Fed’s efforts so far, although there are signs that inflation may ease. My colleagues Tracy Alloway and Joe Weisenthal have listed a variety of prices that have fallen, including industrial metals, shipping rates, used cars and lumber. Year-over-year PCE peaked in February and has declined every month since. The market is also signaling that inflation has peaked. The five-year equilibrium rate fell back to 2.6% after peaking at 3.6% in March.
Even so, critics argue the Fed should be more aggressive, but its measured approach now looks cautious. Real gross domestic product contracted 1.6% in the first quarter and the Atlanta Fed estimates another contraction of 1.6% in the second, so the US could already be in a recession. The fact that this is not the case for many people is testament to the balance the Fed has achieved so far. If the Fed manages to bring inflation down with only a mild recession – a so-called soft landing – it will be a major coup. More drastic measures may still be needed, but given the damage they would cause to the economy, it is wise to see if a lighter touch is enough.
I suspect some of the criticism also stems from disapproval of previous Fed interventions, some of which I share. I wouldn’t have lowered interest rates as much as the central bank did in response to the dot-com meltdown in the early 2000s. I also understand the anger many feel at the thought of having to saving the Wall Street banks in 2008 after they nearly brought down the financial system. They were different Feds, though, and it wouldn’t be fair to tar this Fed with that story.
Nor is it fair to expect that the Fed saw this surge in inflation coming. No one can predict inflation reliably; if that were possible, inflation would not be a problem because central bankers would always anticipate it. There were many predictions after the financial crisis that the trillions of dollars mobilized to revive the financial system would trigger runaway inflation, but inflation never came.
The reality is that a data-driven approach to monetary policy, which the Fed is right to pursue, will always be a slow step because economic numbers come with a lag. But considering the data available to the Fed and the decisions it has made in response, it appears that it has done as well as can reasonably be expected.
More other writers at Bloomberg Opinion:
• The Fed must overcome these four failures: Mohamed El-Erian
• Data-driven Fed lacks data to change plan: Jonathan Levin
• The beast of inflation won’t sit still: Allison Schrager
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management company.
More stories like this are available at bloomberg.com/opinion
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