The Fed is Powerless to Stop Inflation.But It Can Start a Recession.

The Fed is powerless to stop inflation

The Federal Reserve Chair Jerome Powell’s news appearance on Wednesday struck observant listeners as heartbreaking. It was the sound of a man who had been assigned a job he knew was impossible yet felt obligated to complete.

The most telling moment came when Bloomberg’s Matthew Boesler noticed the removal of a sentence that had previously been in Federal Open Market Committee announcements. They used to say that a return to 2% inflation was consistent with ongoing healthy labor markets, but that is no longer the case. Was this a sign that the Fed was preparing for a downturn?

Well, Powell responded, it might still be possible to bring inflation down without a recession. “Those approaches have gotten considerably more hard due to variables that are outside of our control,” he continued. [like] the aftermath from the Ukraine conflict, which has resulted in a jump in oil, food, fertilizer, and industrial chemicals costs, as well as supply chains in general… On its face, that line implies that monetary policy alone is capable of accomplishing this. And that didn’t feel like the right thing to do.”

This was the turning point. Current inflation, according to the Fed chair, is primarily due to factors that have little to do with credit conditions in the United States.

In other words, we’re dealing with a project that requires a sewing machine or possibly a fire extinguisher, but Powell only has a hammer. However, as the rest of the press conference demonstrated, he intends to keep swinging it.

Let’s take a step back for a moment. The current macroeconomic orthodoxy places economic management in the hands of the central bank, which is primarily reliant on a single tool, the overnight interest rate between banks. This arrangement is based on a certain economic model. In this model, the supply side—a country’s labor and business productive capacity—grows at a steady rate. Meanwhile, spending may accelerate or slow, depending primarily on financial system developments. As businesses take advantage of cheap financing and households of their paper wealth, asset bubbles may elevate desired expenditure beyond what the economy can supply. Bank failures may stifle credit, causing spending to fall short of its potential.

If these assumptions are correct, it seems reasonable that the financial system’s apex institution is also in charge of managing macroeconomic imbalances like inflation and unemployment.

However, the assumptions may not be correct. Supply-side disruptions may cause macroeconomic disruptions rather than demand-side disruptions. Demand might fluctuate for a variety of causes that are unrelated to finance. It’s possible that supply and demand aren’t mutually exclusive. Demand that is low can discourage capacity-building investment, whereas demand that is high can promote it.

In these situations, the Fed’s control over the financial system may not be sufficient to keep the economy stable. Attempts to mitigate supply interruptions by changing credit flows elsewhere may fail to address the underlying issues, or potentially exacerbate them.

Until recently, the Fed appeared to believe that current inflation was the type of issue that it was designed to address. Rising prices were cited earlier this year as a symptom of too much demand and “tight to an unhealthy level” labor markets. Higher interest rates would dampen labor demand, as slower pay growth would be passed on to lower prices. The stated goal as recently as May was to “bring wages down.”

Powell, on the other hand, has since conceded that he was aiming in the wrong direction. “Wages are not largely responsible for the inflation we’re seeing,” he stated in another surprising statement from the news conference. This conclusion is in line with what other economists have discovered. But it begs the question: if salaries aren’t the source of inflation, why are we combating it with tactics that primarily target wages?

It turns out that today’s inflation has nothing to do with an overheated economy. The main reason for this is due to global influences. The United States stands out among rich countries for the size of its stimulus spending during the last two years. However, it performs in the center of the pack when it comes to inflation. “A lot of countries are looking at inflation approaching 10%,” Powell said, “and that’s mostly related to commodity prices.”

Since Russia’s invasion of Ukraine, energy costs, which appeared to have steadied by the end of 2021, have risen steadily. This, maybe more than anything else, contributes to the sense of panic around inflation. “Gas costs are… not something we can do anything about,” the chairman argues.

What the Fed can do is inhibit new housing development (starts plunged 14% in May), making housing more expensive in the long run, not less. What the Fed can do is shift negotiating power from employees to businesses in the labor market, forcing wages to fall farther behind the cost of living. The Fed has the ability to send the economy into recession if it pushes hard enough.

Powell is well aware, as his press conference demonstrated, that none of this will address the true causes of rising prices. However, it is his job, and he intends to keep it.

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