2022.08 The Taiwan Banker NO.152 / By Peter Chow
Inflation Tests the Biden AdministrationBanker's Digest
The US consumer price index rose 8.6% in May, and the Fed raised its benchmark interest rate by 0.75% on June 15, the largest rate increase since 1994, reaching 1.50%-1.75%. Stock and bond markets experienced strong volatility. The Dow Jones Industrial Average fell below 30,000, and price indices rose 9.1% in June, but on July 13, the Dow Jones fell only 208.54 points, still holding above 30,000. On July 27, the Fed raised rates another 0.75%, bringing the base rate to 2.25%-2.5%. Financial markets however reacted surprisingly calmly that day, and the three major stock market indices all rose to various degrees. In the past, there was a saying that when America sneezes, Japan catches a cold, and the rest of the world suffers from pneumonia. This article will explore the causes of recent inflation, the fiscal and monetary response, and whether tightening will necessarily lead to higher unemployment. The Fed has targeted 2% inflation for nearly 20 years The Fed has been targeting 2% inflation for years, and has maintained a quantitative easing (QE) policy as long as inflation doesn't rise above 2%. In fact, its near-zero rate policy has distorted the normal operation of financial markets. The interesting part is that the continuous QE did not cause substantial inflation before 2021. It reduced the cost of holding money, and slowed down the circulation of money, helping offset the pressure on prices caused by monetary easing. Using the equation of exchange (MV=PQ), M represents the money supply, V represents the income circulation velocity of the currency, P represents prices, and Q represents real output (income). Empirically, if PQ is represented by nominal GDP and M is represented by broad money supply (M2), velocity V=PQ/M can be estimated. Over the past 20 years, money velocity has been decreasing by year. As shown by the author’s calculations (Figure 1), V was 0.7 in 2000 1Q and declined continuously to 0.4 in 2021 IQ, which is why the Fed was able to repeatedly continue its QE policies without fear of inflation. The good times did not last. After the spring of 2021, price indices rose past the 2% target. However, the Fed waited for a whole year before raising its benchmark rate by 0.25% for the first time in March 2022 (Figure 2). Source: US BEA Demand-driven coupled with supply chain disruption Inflation is caused by the textbook factors of supply and demand. Unlike previous experience, this inflation is demand-driven, generated by persistent zero interest rates, coupled with supply imbalance from supply chain interference. The war in Ukraine has also exacerbated gas and grain shortages. The US maintained a zero-rate policy for many years, going beyond the need to stimulate the economy. The Fed often judges price fluctuations and monetary policy operations. This not only involves debates between hawks and doves, but also meets the political needs of the ruling party wishing to prolong growth. In fact, the recession caused by COVID ended in 2020 3Q (see Figure 3), and the overall US economy grew well through 2021 (as shown in Figure 4). The economy grew 6.3% in 2021 1Q, and the next three quarters remained at 6.7%, 2.2% and 6.9%, respectively, with unemployment rates mostly below 4%. As far as the overall growth is concerned, the Fed could indeed start tightening measures in 2021. Why did it not take action in a timely manner? First, we know that 2021 1Q was the early days of the Biden presidency. The so-called core CPI, which strips out food and energy prices, was only 1.4%, and the Fed didn’t want to hit the brakes as soon as a new president took office. Source: US BEA Source: US BEA The Fed chair’s term structure and policy delays The seven directors of the Federal Reserve are nominated by the president and approved by the Senate for a term of 14 years. However, the term of the chair is only 4 years, which doesn’t align with presidential terms. Often, it is only after the new president takes office for a year that the chair’s term reaches 4 years. President Biden took office in January 2021, and Fed Chair Jerome Powell’s term only expired in February 2022, so in 2021, there was little easing. Was this because Powell had a campaign mentality? (The Federal Open Market Committee (FOMC) decides policies by a majority vote, but the chair still has fairly strong leverage.) Although Biden re-nominated Powell in November 2021 in order to stabilize confidence, the Senate did not pass a motion agreeing to re-appoint him until May 2022. Some assert that monetary tightening action could have been taken after he was re-nominated. With the Democrats’ fragile Senate majority, however, Powell remained quiet, and waited until February 2022 to raise rates, after the Senate Finance Committee tentatively approved his re-nomination. The March FOMC meeting decided to raise the benchmark rate by 0.25%, the first time the US raised rates in the past 10 years. It then raised rates by 0.5% in mid-May. Exacerbated by COVID and the Ukraine war In addition to the political factors, there was also a policy justification for waiting. In 2021, the Fed and Treasury Secretary Janet Yellen repeatedly emphasized that inflation was only transitory, so Powell’s 2021 policy was supported by the Treasury. It is worth mentioning that Yellen is an economist with practical experience and former Fed Chair. At the time, Biden was promoting a stimulus package of $1.9 trillion; as Secretary of the Treasury Department, Yellen hoped that the expansionary fiscal policy would be matched by a loose monetary policy. Therefore, the Biden team has been blamed for supporting the low-rate policy, leading to the current inflation of 8.6% to 9.1%, forcing Yellen to admit that her judgment was wrong at the time. Alan Blinder, a professor at Princeton University who was also a former member of the Fed Board, summed up the two factors which deepened the inflation. First, the pandemic increased inflationary pressure by 1.3%-2%. Second, the Ukraine war added fuel to the fire, increasing it by 2.6%. These two factors combined (3.9%-4.6%) contributed to the inflation of 8.6% and 9.1% in May and June. In fairness, overall economic performance since Biden's inauguration (as shown in Figure 5) has been satisfactory. The unemployment rate has remained at around 3.6%, and the number of vacancies is more than twice the number of job seekers, which has been rare in recent years. As Yellen said in an interview on June 19, “the labor market is very strong, arguably the strongest of the post-war period.” Source: US BEA Americans are most dissatisfied with the loss of income from inflation According to the famous monetarist Milton Friedman, “there is a long and variable lag for monetary policy to take effect.” In the past, this was estimated to take about 18-24 months. A recent remark by former Treasury Secretary Larry Summers at Barons argued the time lag at 9-18 months, and a Fed research report said that inflation can be expected to moderate only in 2023. It forecast it to drop to 5.2% by the end of 2022. It is difficult to definitively estimate when the target of 2% might be reached. According to multiple polls, inflation is the issue with which Americans are with most dissatisfied with the Biden administration. The working-class population, whose salaries are limited by contract, cannot increase their salaries until contracts are renewed. If their salary does increase, it will still not keep up with inflation, so their actual income declines, which of course causes dissatisfaction. Facing midterm elections in November, the Biden administration is indeed under pressure on all fronts. Furthermore, previous incumbent parties have lost more or fewer congressional seats in each mid-term election. Currently, the Senate is 50-50 Democratic, and the House of Representatives only has 220 Democratic seats out of 435. Inflation disrupts Biden’s plans The Trump administration’s tariff policy on Chinese imports is currently under review, with both the Treasury and the Commerce departments leaning toward reducing the tariffs to reduce the burden on consumers. However, trade negotiators believe that until China implements its first phase commitments, tariffs are too important of a bargaining chip in trade negotiations to be given up. Moreover, according to a study by the Peterson Institute for International Economics, if the 2% tariff is completely eliminated, prices will only be reduced by 1.3%. According to current observations, the Biden administration will reduce tariffs on some consumer goods for now, but may not ease them on sensitive technologies. Otherwise, even though the Republican Party has traditionally advocated reduce trade barriers, Biden will surely be attacked by the Republicans in the midterm elections for being weak on China. In addition, lower tariffs will also be opposed by unions, who have long supported Democrats. Fighting inflation has become the first priority of the Biden administration, but it has disrupted many of his original policies. Its goal to promote green energy is in conflict with this aim. Early in his term, Biden scrapped the Keystone XL pipeline and froze federal land leases to the oil & gas industry. These policies do not prevent gas prices from rising, and the $2 trillion Build Back Better Act could only shrink. The Fed alone cannot fully address inflation There are other policy tools besides interest rates to tighten monetary policy. The Fed held about $6.23 trillion in Treasury bonds in 2022 IQ. According to reports, it planned to sell $47.5 billion per month from June to August, including $30 billion in government debt and $17.5 billion in agency and mortgage-backed securities, before shrinking by another $90 billion per month ($60 billion in government debt and $30 billion in agency and mortgage-backed securities), but this process could take some time to tighten to the $3.56 trillion of 2020 1Q. The current inflation is beyond the control of the Fed, and cannot be solved by the Fed alone. On the supply side, countermeasures should be taken, such as release of gas reserves, suspension of federal gas taxes, reduction in prescription drug prices, unclogging of ports, adjustment of supply chains, and resolution of the knock-on effects caused by chip shortages, especially for automobiles. Of course, this is not a problem that can be solved overnight, but these measures can reduce inflation expectations of the public. When the public has a trust deficit in the government, it can cause a self-fulfilling prophecy. Expectations have eased slightly, which is welcome news, with a report finding that consumer inflation expectations for three years from now fell from 3.9% in May to 3.6% in June. Fighting inflation won't necessarily lead to recession and unemployment A great deal of controversy exists among scholars regarding the textbook tradeoff between the inflation rate and unemployment; there seems to be no empirical evidence to show a clear negative correlation between the two. Figure 6 shows is the inflation rate and unemployment rate over the past 20 years. There is a weak-fitting curve, but most data points do not fall on that line. It is difficult to find any negative correlation between the two, therefore, measures to combat inflation will not necessarily bring about a recession and increase the unemployment rate. This depends on whether the soft landing is successfully executed. Moreover, the current unemployment rate is only 3.6%, which is still reasonable. On the whole, the US is still performing better than many other economies. If prices stabilize over the next two years, and the economy does not experience a sharp recession or even grows moderately, then this past driver of the global economy will continue to move forward. The author is Professor of Economics at the City University of New York.