Source: Washington Post
The Federal Reserve’s missteps in waiting too long to tackle the greatest run-up in prices in four decades has shaken trust across markets and the American public that it is up to the task of curbing inflation.
On the eve of a high-stakes Fed policy announcement, investors, economists and policymakers were on edge over how sharply the Fed would raise interest rates to deal with inflation, which hit a new peak in May.
Financial market volatility and losses deepened on Tuesday, fueled by fears that the Fed continues to misjudge inflation and will come down too hard on the economy, prompting a recession. The S&P 500 has fallen into bear market territory — a 20 percent fall from the most recent high — and all the indexes have accelerated losses for the year.
Even more concerning are new signs that families have lost faith in the Fed’s policies. Consumer sentiment in June sank to a low not seen since the 1980 recession, according to a University of Michigan survey. Similarly, a poll by The Washington Post and George Mason University’s Schar School of Policy and Government found that most Americans expect inflation to worsen and are adjusting their spending habits, a mind-set that can make the surge in prices even worse.
After initially saying in 2021 that inflation would be transitory, the Biden administration has shifted to calling inflation its “top domestic priority.” (Video: JM Rieger/The Washington Post)
Most Americans expect inflation to get worse, Post-Schar School poll finds
Fed policymakers were already under enormous pressure to slash inflation without inviting disaster for the recovery or spurring a new round of job losses. Now, the Fed is in an even more fraught position, one that goes beyond monetary policy and instead targets the Fed’s most essential tool of all: its credibility.
“It’s very difficult to regain credibility after you’ve lost it,” said Chris Rupkey, chief economist at the research firm FWDBonds. “I know the Fed thinks they have the tools to rein in inflation, but it’s gone so far that now it’s unclear if they have the tools to do that short of raising interest rates to levels that send the economy over the cliff.”
Paradoxically, a big reason Fed policymakers misjudged inflation was because of their strict resolve to avoid the kind of slow labor market recovery that followed the Great Recession, when it took nearly a decade for millions of workers to get back into jobs. Last year, policymakers failed to clearly understand how the pandemic recovery was unfolding in real time, and how few lessons from the last crisis could be applied. Workers returned to work far sooner than expected — though the data didn’t show it immediately — while inflation burrowed deeper into the economy, growing into a bigger threat.
“The pandemic recession was quite different from earlier recessions, which made reading the labor market and assessing the persistence of inflation more difficult than usual for monetary policymakers,” said Ben S. Bernanke, who chaired the Fed from 2006 to 2014.
The process of earning back the public trust could hinge on how the Fed acts this week. Policymakers wrap up a meeting on Wednesday with a new announcement on interest rate increases, which cool off the economy by making a variety of lending, from mortgages to business investments, more expensive. Fed Chair Jerome H. Powell will also appear at a news conference Wednesday afternoon, where he’ll be pressed on the Fed’s plans to stabilize the economy.
For weeks, the Fed had set expectations for an increase of half a percentage point, as it did in May, in the latest of seven rate increases slated for this year. But the most recent and bleak inflation report raised the possibility that Fed leaders will consider a more aggressive increase — three-quarters of a percentage point — to meet the sense of urgency and start to get inflation under control. It would be the sharpest increase since 1994.
“What we need to see is inflation coming down in a clear and convincing way, and we’re going to keep pushing until we see that,” Powell said at the Wall Street Journal’s Future of Everything Festival on May 17.
However, the Fed has a long way to go in convincing the markets, lawmakers and the general public that it can act with enough force without driving up unemployment, or moving so abruptly that the economy lurches back into a recession.
U.S. policymakers misjudged inflation threat until it was too late
Origins of Fed’s missteps
The Fed’s mistakes have become clearer with hindsight.
Back in 2020, the Fed took on the coronavirus public health crisis with a strong focus on the labor market. Shutdowns and a sharp recession had sucked 20 million people out of the workforce that spring. The Fed was determined to get the labor market back to its pre-pandemic strength, and it pledged to keep up its support for as long as necessary.
Fears of a slow recovery were fresh as Fed leaders debated how long to keep supporting the economy. In September 2020, the Fed said it would keep interest rates near zero — a huge sign of support for the economy — until it saw two major signs of progress.
First, the labor market needed to reach what’s known as “maximum employment,” meaning everyone who wants a job can get one. And second, inflation, which hadn’t been a problem in years, would be allowed to go up beyond the Fed’s normal threshold of 2 percent. Fed policymakers didn’t want to see prices surge, but they were willing to tolerate slightly higher inflation than normal if that meant more people could get back into jobs.
Not all officials agreed. Robert Kaplan, then president of the Dallas Fed, voted against the Fed’s announcement, saying the Fed should have more flexibility on when to raise rates down the line. Part of Kaplan’s fear, he explained in an essay, was that if the Fed waited until the two parts of its test, especially on maximum employment, had been fully met, other problems could take root. The world was bound to look different as the coronavirus economy evolved, in “ways that are predictable and ways that are likely not predictable,” Kaplan wrote at the time.
“These fragilities and tail risks are often much easier to recognize in hindsight than in real time,” he wrote.
The move to focus on getting the labor market back to maximum employment ultimately slowed policymakers’ ability to pivot and check inflation as quickly as they needed to. And as the months wore on, more Fed officials would speak out about the risks of waiting for total job market progress as inflation crept higher.
Just before Biden’s presidency kicked off in January 2021, the economy was shedding jobs again, fueling new fears of a slow-to-heal job market. Through the $1.9 trillion American Rescue Plan, the new administration and Democratic-controlled Congress sent the overwhelming message that after the Great Recession, Washington had not done enough to help workers. They would not repeat the mistake.
Biden’s push for a huge relief bill, coming so soon after previous stimulus efforts, found a surprising ally in the Fed, as Powell waved off concerns that a surge of spending would result in too much inflation, and cautioned that the job market still had a long way to heal.
Lawrence H. Summers, one of President Barack Obama’s top economic advisers, warned about inflation risks, along with Republicans, who were worried about too much government spending. But the consensus at the Fed, the White House and among many outside economists was that inflation hadn’t threatened the economy in years, and even stimulus relief as large as the American Rescue Plan wouldn’t fundamentally change that.
But that assumption didn’t account for the pandemic’s outsize impact on supply and demand. New $1,400 stimulus checks, extended unemployment insurance and a revamped child tax credit boosted Americans’ ability to spend and padded their bank accounts. And people’s insatiable search for furniture, construction materials and everything in between quickly collided with broken supply chains. People wanted to buy cars, but a global semiconductor shortage hampered production. People wanted to build or remodel homes, but the lumberyards couldn’t meet the demand.
“Economists tend to rely on statistical models, but they’re only as good as the kinds of shocks that appear in the data that they’re modeling,” said Eric Rosengren, who at the time was president of the Boston Fed. “There were no sequences of supply shocks in that 20-year period, or really over the previous 40 years.”
As inflation crept up throughout 2021, officials weren’t seeing enough progress in the labor market. Monthly jobs reports came in weak, especially when the delta variant of the coronavirus was raging. Economists thought the pandemic was holding back hiring yet again.
But that proved to be wrong. The job market was going gangbusters — the first snapshots of the labor market just didn’t show it yet. Between June and September 2021, the Bureau of Labor Statistics missed more job growth than at any other time on record, underestimating job growth by a cumulative 626,000 jobs.
The revisions made plain how quickly the economy was booming, and how difficult it was to see.
Winning back Americans’ trust
By 2022, the Fed was in full catch-up mode. It moved up its plans for rate increases and the end of its asset purchase program, hoping a steady stream of increases beginning in March would offer enough of a runway. But Russia’s February invasion of Ukraine upended the Fed’s plans, roiling global energy markets and sending gas prices on a tear.
The strain continues to hit families hard. Inflation has weighed on President Biden’s approval numbers and put the onus on Fed officials to acknowledge, even belatedly, the toll of higher prices. After the Fed’s last policy meeting in May, Powell took the podium and began his regular news conference in a rather unusual fashion, staring into the camera and saying he wanted to “speak directly to the American people.”
The Fed raised interest rates by a half a percentage point — its most aggressive move since 2000 — and has since started drawing down its nearly $9 trillion balance sheet.
While there have been a few signs of cooling in the housing market, most Americans aren’t yet feeling relief in their daily lives. Over the weekend, the national average for a gallon of gas hit $5, and the cost to fill a tank is $100 or more in many parts of the country. Grocery prices, in particular, rose sharply in May, with the food index climbing 10.1 percent for the year, the first double-digit increase since 1981. And rents, which have been slowly marching upward, rose again in May, compared against April figures.
In early June, U.S. consumer sentiment plunged to the lowest level since 1980, according to the closely watched University of Michigan survey. A report from the New York Fed showed that the public’s expectations for short-term inflation rose in May, to the highest level seen in a survey that dates to 2013.
The change in consumer sentiment is particularly problematic, because if households don’t trust that price increases are temporary, they start changing their behavior and make inflation even tougher to manage. Indeed, a poll by The Washington Post and George Mason University’s Schar School of Policy and Government found that most Americans are beginning to account for inflation. About 6 in 10 (59 percent) people say they are driving less, minimizing their use of electricity and saving less, while about half (52 percent) say they are trying to buy products before prices rise, the poll finds.
“Not only is the Federal Reserve faced with the risk of inflation becoming embedded into consumer and business expectations, but it must also factor in market behavior into its policy decisions,” Joe Brusuelas, chief economist at RSM, wrote in a Tuesday analyst note. “We now call on the central bank to hike rates in such a way to restore investor confidence and maintain well-anchored, medium-to-long-run inflation expectations.”
Ultimately, even a more aggressive push from the Fed may not be enough to give businesses and families the assurance they need. Rate increases can’t lower gas prices, mend supply chains or persuade people to seek out jobs.
Franz Tudor, chief executive of a beverage company in Florida, said he is increasingly unsure that the Fed’s interest rate boosts will solve his most pressing supply chain problems.
Trucking costs for Coco Cocktail, an alcoholic sparking coconut water, tripled last year and are up an additional 70 percent this year because of rising fuel prices and a shortage of drivers, he said. Tudor feels that slowing the economy by raising interest rates will only end up hurting him and other small-business owners who will have to deal with dampened demand and persistent supply snarls.
“Why are we going to raise rates? It’s not going to fix bottlenecks at the port or bring down my shipping costs,” said Tudor, who lives in San Antonio. “I’m not going to be a conspiracist, but it feels like creating demand destruction to correct inflation sends us into a recession, which is a big concern for me. It’s little businesses like us that will go out.”