Bloomberg editorial: Fed must not lose its cool due to rising inflation

Inflation is too high to be considered transitory. Prices in the United States increased 7% in 2021, the largest increase in almost 40 years. Remember: The Fed’s inflation target is 2%, a fact that gets less attention than before, when the dovish and dovish trenders measured deviations in tenths of a percentage point. It is an overreach and some of it is likely to become persistent without corrective action.

The good news is that the Fed can no longer be accused of downplaying the risks. In the past two months, his political stance has quickly shifted from patience to concern, with a hint of alarm. Central bank Chairman Jerome Powell told lawmakers this week that he viewed inflation as a “serious threat”.

So far, to its credit, the monetary authority has managed to make this abrupt change in messaging without rocking the financial markets. Investors expect the Fed to quickly withdraw its bond-buying program and have calmly anticipated four interest-rate hikes this year, starting in March.

Will that accelerated programming be enough? It seems appropriate, but with the pandemic far from contained and new uncertainties surrounding the omicron variant, it’s impossible to be sure. The Fed must keep an open mind and be ready to tighten or ease monetary policy as conditions evolve.

The reasons for the price increase are quite clear. Unprecedented supply chain disruptions have slashed production, while unprecedented fiscal and monetary stimulus pushed demand to the max.

Looking ahead, fiscal policy is likely to be much less aggressive (assuming President Joe Biden’s stalled “Build Back Better” plan finally passes, it would likely involve only modest additional stimulus).

And accommodative monetary policy is slowly being withdrawn. Even allowing for a spike in inflation to have the effect of loosening monetary policy (by lowering the real interest rate), the Fed is no longer deliberately stimulating demand.

However, while the demand side is under more control, the supply side remains a black box. The omicron variant is so transmissible that it is already causing new serious disruptions and ruining plans to get back to normal. On the other hand, after two years of COVID-19, policymakers seem to be reconsidering the balance between caution in disease control and economic disruption caused by strict lockdowns.

Adding to these uncertainties are looming questions about the medium term and beyond. What kinds of permanent changes, if any, will the pandemic bring about in the way work is organized? And how many pandemic-related exits from the workforce will be reversed once savings, currently fueled by high asset prices, begin to dry up?

Right now, the job market is unequivocally tight. The unemployment rate stands at 3.9% and, more pertinently, there are clear signs that wages are rising both in response to labor shortages and to offset rising prices.

This incipient spiral of wages and prices, if it continues, threatens to entrench part of the current inflationary increase and make it persistent. In the coming months, this will be the key indicator to judge whether the Fed’s corrective action is sufficient.

Amid all the uncertainty, what is crucial is that the central bank is no longer seen as locked into a fixed policy. Once again, Powell nailed this when he said on Tuesday that the central bank would have to be “humble and agile”. Exactly.