What the Fed Got Wrong on Inflation

Somewhere over the rainbow, The Wizard of Oz, the classic children's story by Frank Baum, is partly about monetary policy. There's a famous moment where Dorothy's dog, Toto, pulls back the curtain and reveals the wizard to be just a man with a loudspeaker.

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In a way, the COVID pandemic and the inflation that followed have been a "Wizard of Oz" moment for the Fed, the ECB, the Bank of England, and other central banks. We thought they were maestros, all-powerful geniuses. Then came the COVID shock. The lockdowns caused severe supply shocks as factories shut down worldwide, while government stimulus meant to keep the economy afloat drove a surge in inflation. Central bankers were slow to recognize inflation was taking off, and once it did, they didn’t have the tools to quickly control it.

To the Fed’s credit, when they decided to raise rates rapidly to correct course, they committed fully. Jerome Powell was clear: they would do whatever it took to bring price stability back. Many people think the Fed has redeemed itself, but the world has changed.

Central banks may have won the battle to bring inflation back to their 2% target, but in the years ahead, we may find they have lost the war over how inflation is managed. When interest rates go up, it becomes more expensive to borrow, reducing spending and cooling the economy, bringing inflation down. Conversely, when unemployment is the problem, central banks cut interest rates, making borrowing cheaper and stimulating demand, which boosts the economy and creates job opportunities.

Monetary policy can be compared to the Fed manipulating a kite. The tension at the end of that kite string affects the economy. In the U.S., to ensure banks have enough money to cover withdrawals, they are required to keep some reserves with the Federal Reserve. The Fed’s main policy tool, the Federal Funds Rate, affects the short-term interest rates that banks charge each other, which trickles down to businesses.

For decades, central banks have controlled credit flow to stabilize prices. But now, trade wars, actual wars, and climate change are creating new inflation risks from supply shocks. China's entry into global trade was a major disinflationary shock, but today, China is more expensive, and frictions between China and the U.S. are driving up prices. Globalization's disinflationary effects are reversing, and deglobalization is leading to higher prices.

We now live in a world of "hot wars" like Russia's invasion of Ukraine, which disrupted gas and oil supplies to Europe, amplifying inflation. Climate change is also part of the picture. Carbon taxes would help fight climate change, but they would add to inflationary pressures. The Fed’s tools can only raise or lower aggregate demand; they can’t address supply issues.

Fiscal policy and tax policy can impact supply. There’s a debate over what new tools are needed to control prices and keep inflation low, and many of these tools are outside the central banks' control. The pandemic economy has been unlike any other, with much to be learned. One key lesson for central banks is that keeping inflation on target is going to become harder. Inflation recently exceeded the 2% target, and political support for strong, independent central banks is far from guaranteed.

Unemployment is rising, marking a turning point for the U.S. economy and the Federal Reserve. Under a second Trump presidency, would the Fed retain its strength and independence, or would it face political pressure to set monetary policy based on the electoral calendar?

It's estimated that 80% of consumers are feeling financially stretched, paying over 20% interest on credit cards. If the Fed cuts rates, credit card interest would decrease, but a recession caused by the Fed could cost people their jobs, leaving them unable to pay their bills. Powell is under pressure to restore price stability and generate a soft landing for the economy. Since World War II, the Fed has successfully achieved this soft landing only once, in 1995, under Alan Greenspan. Paul Volcker, in contrast, brought on a deep recession in the 1980s but was still praised for controlling inflation.

The lessons from Volcker and Greenspan show that a central bank’s reputation depends on maintaining price stability while allowing the economy to grow. Today, Powell faces the tension between high inflation risks and lower growth.

We are living in a world shifting from globalization to deglobalization, with climate change as a new factor. In the future, central banks will still play a leading role, but they won’t be the only players.