America’s economy needs tighter monetary policy

THE FEDERAL RESERVE has spent most of 2021 saying that high inflation would be temporary. And yet price rises have persistently overshot forecasts, reaching 5% in October, on the Fed’s preferred measure, even as employment remains about 4m short of its pre-pandemic level. On December 15th the Fed will decide whether to tighten monetary policy, probably by accelerating the pace at which it “tapers” its monthly purchases of assets, mostly government bonds, which are currently running at $90bn per month. It should go ahead and take action. Though uncertainty is high, the Fed must rapidly respond to the data it has today and then adjust as necessary as conditions evolve. Those data indicate that it has already fallen behind.

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The rise in prices cannot be explained by a few shortages, such as of second-hand cars. In October the median item in the consumer-price index was 3.1% more expensive than a year earlier. Clothes prices were up 4.3%, shelter (such as rent) was 3.5% dearer, and transport cost 4.5% more. In the third quarter private-sector wages and salaries grew at an annualised rate of 6.5%—too fast to be compatible with the Fed’s 2% inflation target without incredible productivity growth.

It is true that temporary factors have driven up inflation. The $1.9trn fiscal stimulus President Joe Biden signed in March will not be repeated (the outlay proposed in the Democrats’ social-spending bill is more spread out and partly offset by tax rises). During the pandemic, consumers have binged on goods. Supply chains have been bunged up, especially as the world’s factories have faced lockdowns and staff absences. Despite an abnormal number of Americans out of work, firms have struggled to fill vacancies.

However, predicting when these pandemic-related forces will ease is a fool’s errand, especially now that the Omicron variant is spreading. For as long as inflation remains high, there is a growing danger that it will become entrenched. The New York Fed estimates that the median consumer expects prices to rise at an annual pace of 4.2% over the next three years, up from 3% in January 2021, suggesting they may demand higher wages. Rising inflation expectations also reduce the effective cost of credit, because inflation makes debts easier to repay. The real interest rate over five years on government bonds is about -1.6%, lower than in almost all of 2020, when the economy was far weaker.

The latest argument from some doves is that nominal GDP, or total cash spending in the economy, is merely on its pre-crisis trend. This proves that pandemic-related distortions, not excessive demand, have driven up prices, they say. Yet though this argument held in the third quarter, it may already be out of date. Nominal GDP is expected to grow at annual rates of over 10% in the fourth quarter, compared with the trend rate of just 4%. America is seeing an unusual surge in demand, not just constrained supply.

Tighter monetary policy is therefore justified. But if you believe the Fed’s theory of how its asset purchases work, every bond it buys adds fresh stimulus to the economy. It follows that merely tapering the pace of purchases is not tightening. So why not raise interest rates instead? The answer is that the Fed is bound by its past guidance that it would stop buying bonds before raising rates, and that it would avoid ending purchases abruptly. Abandoning that framework would lead investors to question the central bank’s trustworthiness and to expect an excessive number of additional interest-rate increases in 2022.

The good news is that the Fed can taper fast enough to let it raise interest rates in March. If between now and then the pandemic greatly worsens, consumers slash their spending on goods or many missing workers return to the labour force, monetary policymakers can change course again. But they must give themselves scope to raise rates soon. In an ideal world it is an option that would already be on the table.

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This article appeared in the Leaders section of the print edition under the headline “Wind down the money printer”