With high inflation and low interest rates, the US Federal Reserve is playing with fire

The US Federal Reserve has turned on a dime, an uncharacteristic about-face for an institution long noted for slow and deliberate shifts in monetary policy. It has recognised that it has a serious problem.

That problem, of course, is inflation. Like the Fed I worked at in the early 1970s under Arthur Burns, today’s policymakers once again misdiagnosed the initial outbreak. The current upsurge in inflation is not transitory.

It is widespread, persistent and reinforced by wage pressures stemming from an unprecedentedly sharp tightening of the US labour market. Under these circumstances, the Fed’s continued refusal to change course would have been an epic policy blunder.

But recognising the problem is only the first step towards solving it. And solving it will not be easy.

Consider the maths: the inflation rate as measured by the Consumer Price Index (CPI) reached 7 per cent in December 2021. With the nominal federal funds rate effectively at zero, that translates into a real funds rate (the preferred metric for assessing the efficacy of monetary policy) of minus 7 per cent.

That is a record low. Only twice before in modern history, in early 1975 and again in mid-1980, did the Fed allow the real funds rate to plunge to minus 5 per cent. Those two instances bookended the Great Inflation, when the CPI rose at an 8.6 per cent average annual rate.

Of course, no one thinks we are facing a sequel. Most forecasters expect inflation to moderate over the course of this year. As supply-chain bottlenecks ease and markets become more balanced, that is a reasonable presumption.

But only to a point. The forward-looking Fed still faces a critical tactical question: what federal funds rate should it target to address the most likely inflation rate 12-18 months from now?

No one has a clue. But one thing is certain: with a minus 7 per cent real federal funds rate putting the Fed in a deep hole, even a swift deceleration in inflation does not rule out an aggressive monetary tightening to reposition the real funds rate such that it is aligned with the Fed’s price-stability mandate.

To figure this out, the Fed must hazard an estimate of when the inflation rate will peak and head lower. It is always tough to guess the date – and even harder to figure out what “lower” really means.

A view of the US Federal Reserve building in Washington, US. While the Fed expects inflation to moderate in 2022, monetary tightening is still likely to be needed to bring the real federal funds rate back above zero. Photo: Reuters

But the US economy is still running hot, and the labour market, at least as measured by the plunging unemployment rate, is tighter than at any point since January 1970 (on, gulp, the brink of the Great Inflation).

Under these circumstances, I would argue that a responsible policymaker should err on the side of caution and not bet on a miraculous round trip of inflation back to its sub-2 per cent pre-pandemic trend.

Again, consider the maths: let’s say the Fed’s projected policy path, as conveyed through its latest “dot plot”, is correct and the central bank takes the nominal federal funds rate from zero to around 1 per cent by the end of 2022.

Couple that with a judicious assessment of the disinflation trajectory that foresees year-end CPI inflation moving back into the 3-4 per cent zone. That would still leave the real federal funds rate in negative territory at the end of this year.

That’s the catch in all this. In the current easing cycle, the Fed first pushed the real federal funds rate below zero in November 2019. That means a likely minus 2 to minus 3 per cent rate in December 2022 would mark a 38-month period of extraordinary monetary accommodation, during which the real federal funds rate averaged minus 3.1 per cent.

Historical perspective is important here. There have been three earlier periods of extraordinary monetary accommodation worth noting: in the aftermath of the dotcom bubble, the Fed under Alan Greenspan ran a negative real funds rate averaging minus 1.1 per cent for 31 consecutive months.

Following the 2008 global financial crisis, Ben Bernanke and Janet Yellen teamed up to sustain a minus 1.9 per cent average real funds rate for a whopping 62 months. And then, as post-crisis sluggishness persisted, Yellen partnered with Jerome Powell for 37 months to hold the real funds rate at minus 0.9 per cent.

Today’s Fed is playing with fire. The minus 3.1 per cent real federal funds rate of the current uber-accommodation is more than double the minus 1.4 per cent average of those three earlier periods. And yet today’s inflation problem is far more serious, with CPI increases likely to average 5 per cent from March 2021 through to December 2022, compared with the 2.1 per cent average that prevailed under the earlier regimes.

All this underscores what could well be the riskiest policy bet the Fed has ever made. It has injected record stimulus into the economy during a period when inflation is running at well over twice the pace it did during its three previous experiments with negative real funds rates.

I deliberately left out a fourth comparison: the minus 1.7 per cent real federal funds rate under Burns in the early 1970s. We know how that ended.

By now, it is passé to warn that the Fed is “behind the curve”. In fact, the Fed is so far behind that it can’t even see the curve. Its dot plots, not only for this year but also for 2023 and 2024, don’t do justice to the extent of monetary tightening that will most likely be required to bring inflation back under control. In the meantime, financial markets are in for a very rude awakening.

Stephen S. Roach, a faculty member at Yale University and former chairman of Morgan Stanley Asia, is the author of Unbalanced: The Codependency of America and China. Copyright: Project Syndicate