The Fed shouldn’t rule out faster tightening

Prices rose in the US by 8.3% in the year to April, only a little less than the increase of 8.5% in the year to March. Most economists had expected a bigger decline. Inflation, it seems, might have peaked, but the vital question is how quickly it will fall back to an acceptable level. At the moment, the answer appears to be: not quickly enough.
Last week, the Federal Reserve raised its policy interest rate by 50 basis points, to a range of 0.75% to 1%, and said to expect more. But the schedule it’s led investors to anticipate would leave rates substantially negative in real terms for many months yet. Despite the risk that faster-than-expected tightening might tip the economy into recession, the central bank needs to weigh the case for firmer action and prepare investors for the possibility. President Joe Biden’s administration, for its part, ought to start helping rather than making things harder.
The most worrisome aspect of the new inflation numbers was the rise in so-called core CPI, which excludes volatile food and energy components. This went up 0.6% month over month — an annualised rate of roughly 7% — compared with 0.3% in March. The increase in the price of services was especially pronounced, suggesting that the rebalancing of post-Covid demand might brake inflation less than hoped and underlining the danger that inflationary pressures are spreading more widely across the economy.
Guided by Fed statements, financial markets appear to have penciled in a policy rate of about 2.5% by the end of the year. If inflation lingers above 3% into 2023, as now seems likely, the policy rate would still be negative in real terms — hence the Fed would still be providing stimulus. (And this ignores the additional stimulus provided by the central bank’s enormous, albeit diminishing, portfolio of bonds.) Cautious tightening is defensible, given the risks of further financial volatility and a too-abrupt slowdown, but the balance is shifting. The Fed should watch for signs that longer-term expectations of higher inflation are getting entrenched, and be ready to tighten faster.
Questioned after last week’s policy announcement, Fed Chair Jerome Powell said he and his colleagues weren’t actively considering interest-rate increases of more than 50 basis points. Many investors took this to mean there wouldn’t be any. Powell and his colleagues should in fact be discussing increases of 75 points — and more — if the need arises, and markets should be alerted to the possibility. Seeming to rule this out could compound the Fed’s problems by pushing expected inflation higher.
Speaking of compounding problems, there’s the Biden administration. Much of the blame for the spike in inflation lies with last year’s stimulus, delivered on top of powerful fiscal expansion already in place and with the economy running hot. In remarks this week, Biden addressed rising prices, but not in a helpful way. His proposals were familiar, mostly irrelevant to the problem at hand, and in some cases clearly counterproductive. Price fixing by monopolistic companies isn’t the problem. Big new subsidies for child care and long-term care, desirable as they might be in ordinary circumstances, would at the moment only raise demand and put further pressure on the Fed to raise rates. For the same reason, it’s a pity the president didn’t take the opportunity to rule out forgiving student debt.
Until further notice, fighting inflation needs to be the top economic priority. The more clearly the Fed and the administration commit themselves to it, the easier it will be.

—Bloomberg