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Next year’s unpleasant choices confronting the Fed

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The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

Signalling the pursuit of an objective while quietly heading in a different direction is a tactic in politics that is as old as it gets. Now the US Federal Reserve may be forced to consider such a tricky manoeuvre as 2023 unfolds. This is not because it is an optimal approach. Far from it.

Rather, the Fed may end up seeing it as better than the other main options, now that it has fallen well behind an inflation process that is likely to prove stickier than many currently expect, including the central bank.

Since 2012, the Fed has been publicly and explicitly committed to a 2 per cent inflation target. The 2 per cent objective originated in New Zealand in 1990 and gradually spread to several other advanced countries. The target was deemed high enough to allow for the price adjustments needed for the economy’s desirable resource reallocations, while avoiding the zero lower bound trap where, it was thought, interest rates can no longer be cut further to stimulate the economy. And it was deemed low enough to stabilise inflationary expectations.

For a while now, inflation has been running significantly above the Fed’s target. While the Personal Consumption Expenditures Price Index (PCE), its preferred inflation measure, has been declining in recent months, it remains three times the target.

Also worrisome is the morphing of the inflation process. No longer dominated by energy and food prices, the drivers of inflation are increasingly coming from the services sector. Within that sector, the latest monthly US payrolls data showed wages gaining 0.6 per cent in November, twice the consensus forecast and taking the steadily increasing three-month moving average to 6 per cent.

This accelerating wage growth was accompanied with robust monthly job gains. Persistently high job vacancies still outnumber the unemployed by a factor of 1.7 amid declining labour force participation. Combined with input price inflation that is declining slower than consensus forecast, there is reason from services alone to worry that inflation may well continue to overshoot Fed forecasts that have already been consistently revised up.

There are also others, including the rewiring of global supply chains, the changing nature of globalisation and the energy transition. And, of course, the Fed is still playing catch-up to tame rising prices after its protracted gross mischaracterisation last year of inflation as “transitory” and its initially timid steps to withdraw monetary stimulus.

Rather than fall to 2-3 per cent by the end of next year, US core PCE inflation will probably prove rather sticky at around 4 per cent or above. This is what happens when an inflationary moment is allowed to get embedded into the economic system. The world’s most powerful central bank is now confronted with two unpleasant choices next year: crush growth and jobs to get to its 2 per cent target or publicly validate a higher inflation target and risk a new round of destabilised inflationary expectations.

The appropriateness of the 2 per cent inflation target itself is, of course, an issue. It is far from obvious that the Fed would opt for it were it to start afresh today. A target of 3-4 per cent would ultimately be more likely, given the fluidity of the supply side, the energy transition, the required resource reallocations and, of course, the experience with the zero lower bound in the decade of the 2010s.

Given all this, it could prove tempting for the Fed to continue to signal a 2 per cent inflation target but, in practice, end up pursuing a higher one hoping that the public will accept it over time as indeed a superior and stable objective.

This, of course, is far from an optimal approach. It is hard to pull off and involves delicate ethical issues that might raise more questions about the Fed’s accountability, credibility and autonomy. Yet, given the extent of economic uncertainty and financial fragilities, the Fed could end up thinking that this far from perfect policy approach may be the better course of action.

A good friend of mine once observed that an initial set of poor decisions often makes it very difficult to return quickly to an optimal place despite best intentions and efforts to do so. This, unfortunately, is the trap the Fed has fallen into owing not only to its two 2021-22 policy mistakes but also to its over-reliance on unconventional policies in the decade that preceded that. Unfortunately for all of us, its road from here does not get much easier any time soon despite the fall in inflation.


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