The Federal Reserve is speeding down the road looking in the rearview mirror, chasing a demon it doesn’t understand and praying that inflation will recede before it drives the economy into the ditch.
I’m not the only one who worries that the Fed could be racing toward disaster if it raises interest rates
FF00,
too high. The biggest risk to the economy is that the Fed and other central banks will tighten too much, according to 55% of economists surveyed by the National Association of Business Economics.
Fed officials (and by extension everybody on the planet) have two big problems . One is that with its obsession about unemployment, wages, inflation expectations and sticky prices, the central bank is mistakenly concentrating on lagging indicators that will flash too late for it to avert a catastrophic recession or a financial crisis.
The second problem is that the Fed is looking at the wrong things anyway. The Fed’s model of inflation is inadequate at best, and fatally wrong at worst.
The Fed’s model
Let’s assume for a minute that the Fed’s model of inflation is correct.
The Fed’s current policy (based on the Expectations-Augmented Phillips Curve model) maintains that the unemployment rate is too low, which means that the supply of labor is so restricted that workers can demand (and get) higher wages and compel businesses to raise their prices in order to pay their wage bill. Once this wage-price dynamic is set in motion, everybody begins to expect higher inflation in the future and acts accordingly, creating a self-fulling prophecy.
To monitor their progress on bringing inflation back down to the 2% target, the Fed is monitoring the economic data, with a particular focus on wages, the unemployment rate, and the PCE and the consumer price indexes.
The problem is, these statistics are all lagging indicators. They tell us more about where we’ve been than where we are going. I’ve written before about why the CPI and the PCE price index will stay hot long after real-world inflation cools.
Read: Bernanke says Fed shouldn’t use interest rates to ‘fine-tune’ financial stability risks
Leading indicators
To see where inflation is going, it’s better to look at leading indicators of inflation, including commodity prices, house prices, supply times, the value of the dollar
BUXX,
DXY,
growth of the money supply, and financial conditions. Almost all of these have peaked and are now declining. That’s a sign that inflationary pressures are lessening.
If the Fed still wants a soft landing, it needs to heed these indicators. Unfortunately, the Fed, by looking into the rearview mirror, is not paying attention to the road ahead.
For instance, growth in the money supply has long been seen as a source of inflationary pressures. Larry Summers, Jason Furman and others who correctly predicted the 2021-22 inflationary cycle saw that large increases in stimulus (in the form of direct payments to households financed by the Fed’s quantitative easing) would lead to strong effective demand in an environment of restricted supply—a recipe for high inflation.
But that stimulus is now gone. Real disposable incomes are below pre-pandemic levels, and the Fed is shrinking its balance sheet.
The real money supply (adjusted for declining purchasing power) soared at a 66% annual rate in the second quarter of 2020 when the Fed and the Congress turned on the spigot of stimulus; it’s now falling at a 4% annual…
Read More: Opinion: Leading indicators show inflation is slowing, but Fed policy makers are