The reappointment of most American officials, however senior, to a second term would usually attract little attention. Not so Joe Biden’s recent decision to nominate Jerome Powell for a further four years as head of the powerful Federal Reserve. After much speculation about his intention, the US president backed the continuity candidate at America’s central bank. Now Powell faces an alarming economic discontinuity: a massive surge in inflation.
The return of high inflation has come as an unwelcome surprise, not least to the Fed, which is charged with maintaining overall price stability and in practice targets a low inflation rate of 2 per cent. In June 2020, during the first wave of the pandemic in America, it was forecasting inflation of 1.6 per cent in late 2021. In the event, consumer prices rose by 6.2 per cent in the 12 months to October.
Inflation hasn’t been that high in America since 1990 (briefly) and before then the early 1980s, which saw a peak above 14 per cent. That was when Paul Volcker was in charge of the Fed and subjecting an economy long hooked on inflation to cold turkey. The embodiment of a tough independent central banker prepared to go where politicians feared, his stern policy pushed the Fed’s main interest rate up to a peak of around 20 per cent in order to suppress fast-rising prices.
Volcker was single-minded in carrying out his mission to tackle the post-war bane of inflation. By contrast, Powell is much more of a pragmatist by nature and the emergency he has faced is the pandemic. A former lawyer and investment banker who got the top job at the Fed under Donald Trump, he showed his worth when markets panicked in the spring of 2020 about the economic damage from Covid-19. The Fed intervened decisively by slashing interest rates and pumping money into the financial system through massive purchases of assets.
But central bankers are welcome guests when they ride to the rescue by loosening monetary policy. It is when they take the hard decision to tighten the reins that they have to show their mettle. The jump in inflation creates a new challenge for Powell, who has spent much of his first term, which began in February 2018, fretting about inflation being too low. Last year, a review of the Fed’s strategy culminated in a decision in August 2020 to modify the simple 2 per cent target to one averaging that outcome over time. This would permit a period of above-target inflation following one when it fell below. Setting out the rationale, Powell spoke of “the persistent undershoot of inflation.”
Confronted instead by a sudden overshoot, the Fed appears to have been caught off guard and has resisted making a swift response. Ever since price pressures started to mount this year, it has insisted that the bout of inflation will be “transitory” and should subside before too long. As a result, the central bank has done little yet to tighten monetary policy, leaving interest rates barely above zero while starting only in mid-November to phase out its $120bn-a-month asset-purchase programme in place since June 2020.
Powell and the Fed are not short of arguments to back their view that the upsurge in inflation will be temporary. One big contributor to inflation is a sharp rise in fuel costs, which has been driven by the rebound in global oil prices after they collapsed in the spring of 2020. As long as oil prices don’t go up much further, that will indeed be largely a transitory effect.
More generally, current high inflation reflects the disruption to global supply chains caused by the pandemic. Shortages have become commonplace in America as well as Britain, as wholesalers and shops struggle to obtain a wide variety of products that used to be readily available. That in turn has pushed up prices in the worst-affected sectors.
Again, however, this source of inflation should be temporary, ceasing when supply chains are working properly again. Indeed, researchers at the Bank for International Settlements, a central bank hub, have recently argued that the supply chain pressures have been intensified by over-ordering, with retailers and then wholesalers trying to build up buffers. Once bottlenecks start to clear, the precautionary hoarding should end and this process (the so-called “bullwhip effect”) could go into reverse, ending shortages and pushing prices down.
Most important of all, though prices may now be rising so rapidly, there is not the same inflationary psychology that had taken grip in the 1960s and 1970s. Then, both businesses and consumers had come to expect high and rising inflation. Volcker’s monetary crackdown had to be so harsh because inflationary mindsets had become the norm, affecting price-setting and wage-bargaining. By contrast, the current bout of inflation has come after a decade of subdued inflation that cemented expectations of stable prices.
Despite this reassuring perspective, it is hard for any central bank to disregard an inflationary leap as big as the current one. For one thing, the surge in prices may itself change expectations. For another, the American labour market is much tighter than expected when Covid struck in early 2020. In June that year, the Fed forecast unemployment of 6.5 per cent in late 2021, but the latest figure, for October, is 4.6 per cent. Wages and salaries are now rising faster than before the pandemic.
Credibility matters. If markets and businesses believe that central banks will act fearlessly to curb inflation, that makes their job much easier by holding down longer-term inflation expectations, constraining a wage-price spiral. The readiness of central bankers to break conventional rules in rescuing economies since the financial crisis has led some to wonder just how independent they really are when it comes to enforcing price discipline.
That’s why Powell cannot afford now simply to rely on inflation subsiding of its own accord. Before too long, the Fed will have to show that it is prepared to act, not through any drastic measures but by starting to move interest rates off the floor.