Should Fed tolerate a higher level of inflation?

Coming into this year, the hope was that supply chain improvements and modest interest-rate increases from the Federal Reserve would return US economy to the healthy expansion mode it enjoyed in 2019. Accelerating inflation and anecdotes from companies suggest that’s much less likely to happen than it seemed a few months ago.
The Fed is in a tight corner: Is it better to aggressively jack up interest rates to lower inflation, even if that risks throwing the economy into recession? Or should it tolerate a somewhat higher level of inflation than its 2% rough target to keep the economy growing while cooling off prices? Given these two imperfect choices, the latter is clearly preferable. Making this case begins by casting doubt on the 2022 scenario the Fed envisioned when the year began. In its December meeting, the Fed forecast 2022 growth of 4% for real GDP and 2.7% for core inflation. A strong January jobs report in the face of the omicron variant makes the GDP forecast plausible — the problem is on the inflation side.
The personal consumption price index, the Fed’s preferred measure of inflation, showed annualised readings of 5.4%, 5.9%, and 6.1% in the most recent three months of data ending in December. We should expect something similar for January based on consumer price inflation data. To get anywhere close to the Fed’s forecast of 2.7% for the full year would require core inflation readings at or below 2% on an annualised basis very soon — as in, over the next few months. There’s no precedent for that kind of rapid deceleration in inflation outside of a recession. To be fair, the economy remains disrupted by the impact of the pandemic. In earnings conference calls over the past month, companies ranging from homebuilders to Chipotle have been hopeful that inflationary and supply chain conditions will ease this year. But they don’t expect that to happen for at least the next several months.
This puts the Fed in an unexpected and undesirable situation. A continuing inflation trend of 5% or higher for the next several months — and who would dare to be overly confident looking beyond that right now? — would be much the same as we’ve seen in recent months. But it’s wildly out of step with what the Fed has forecasted, and what it’s indicated it will tolerate.
If inflation isn’t set to slow dramatically on its own, then using monetary policy to engineer an outcome to match the Fed’s forecast by the end of the year would probably require such drastic interest rate hikes that it would destabilise financial markets and bring on a recession. It would achieve the price stability the Fed is looking for, but at a tremendous cost.
The better alternative is to accept for the time being that we won’t have the kind of Goldilocks economic environment we hoped to achieve this year, and that we have to choose between two less-than-ideal options. Progress on inflation should still be the goal, and if that means starting the rate-hike process with a 50-basis-point increase in March, as markets increasingly anticipate, so be it. But once it’s clear that some progress is being made on lowering inflation, the Fed should exercise patience in its drive towards a more desirable level.

—Bloomberg