Americans are suffering from the worst bout of high inflation since the early 1980s. Rent, groceries, gasoline, new cars and many other staples cost a lot more now than they did a year ago.
The surge in inflation has also stunned Washington and Wall Street. Few forecast the spike in prices.
One who did is Stephen Stanley, chief economist of Amherst Pierpont Securities. He sounded an alarm early last year as prices began to escalate. MarketWatch spoke to Stanley about inflation and what the Federal Reserve can do to stop it.
MarketWatch: The reopening of the economy last year and the huge surge in demand that followed gets a lot of the blame for the spike in inflation. Shortages developed and businesses could not keep up. What else is part of the story?
Stanley: There are two main components to the inflation surge. There have been a variety of supply constraints associated with various aspects of the pandemic: the chip shortage for motor vehicles, port shutdowns in China, etc. For most of 2021, the Fed judged that this represented the predominant source of price pressures and would quickly fade.
But there was a second key element. Demand was extraordinarily strong as well. The unprecedented stimulus provided by both fiscal and monetary policy left businesses and consumers awash in liquidity, and the economy does not have the productive capacity to keep up, which has led to an overheating. You could see it early in the housing market and a few other places, but the dynamic has spread across much of the economy.
MarketWatch: You are one of the few economists who was warning about the threat of high inflation before it became a reality. Why did the Fed and so many forecasters fail to see the warning signs?
Stanley: I would not want to suggest that I knew it all the time, and everyone else got it wrong. There have been plenty of things that have turned out far worse than I expected.
Having said that, I would say that the two main things that surprised Fed officials and many economists were: they were very slow to recognize the demand component of inflation that I described; and the supply constraints have proven far more persistent than anticipated.
For example, a lot of us thought that many more workers would return to the labor force last fall, as bonus unemployment benefits expired and Covid faded, but the labor market has only gotten tighter. The supply of workers remains constrained, while the demand for workers has intensified far beyond expectations.
Most, but not all, Fed officials were simply slow to recognize these trends. I strongly criticized Chairman Powell’s August 2021 Jackson Hole speech — which argued that inflation would be “transitory” — at the time. It looked obviously wrong to me when it was delivered, and within a few months, my fears were borne out.
But Powell’s views at the time were hardly outside of the consensus. We got a few tame core inflation readings in August and September, on the back of the Delta slowdown in activity, and there were plenty of economists declaring that inflation had peaked, even as the underlying pressures were building. But then inflation exploded in the fall, and things look much different from Powell’s August 2021 outlook.
MarketWatch: What can and should the Fed do now?
Stanley: The Fed is well behind the curve. We would all be better off if the Federal Open Market Committee had ended asset purchases last summer and had begun to raise rates months ago. But they didn’t, so the question is what is the best approach now.
Policymakers have to balance getting to a more appropriate policy stance fast with not unnecessarily disrupting the economy and financial markets. At a minimum, that probably means hiking by 25 basis points at every meeting for the remainder of the year and commencing balance sheet runoff by mid-year.
However, if inflation continues to gather momentum, the FOMC may have to get even more aggressive. In 1994, the FOMC thought that moving from 3% to 4.25% would do the trick, but then it ended up having to raise rates all the way to 6%. So, we got 175 basis points of rate hikes in the second half of the year that were largely unexpected.
Right now, things seem to be shaping up similarly. Markets see the Fed raising rates substantially this year but then stopping at around 2%. The Fed thinks that neutral is 2.5%. I have a hard time imagining that the Fed can get inflation under control without taking policy into restrictive territory, so I expect a terminal rate in the 3% [range.]
MarketWatch: Can a late-to-act Fed bring down inflation without causing a recession or stock market meltdown?
Stanley: That’s the trick. It’s possible. The Fed did it in 1994, though that was a very different environment, because the Fed was pre-emptive, whereas this time, they are well behind the curve.
If the FOMC is correct that a neutral policy stance would be around 2.5%, then we probably have nothing to worry about in terms of an economic downturn well into next year, but I do worry about 2024 or 2025.
If the Fed can convince the public that it will bring inflation back to 2% in short order, then getting price hikes back under control does not have to be overly painful. I worry that people have already begun to adjust their inflation expectations, in which case the Fed will have a very difficult time getting the inflation genie back into the bottle without derailing the expansion.
MarketWatch: The Fed’s most recent forecast for inflation in 2022 was that it would fall to 2.6% using its preferred PCE price gauge. The PCE barometer was running at a 5.8% yearly rate as of December. Is the Fed wrong again?
Stanley: The FOMC’s December projections are proving to be way off.
At the time, I was 50 to 100 basis points higher. Now, I have 4% or more by the fourth quarter of this year. So, to be fair, we can assume that the FOMC projections will be higher in March.
What I am eager to see is whether they continue to nudge their forecasts up by a few tenths at a time, remaining well behind the actual trends, or they actually make a bigger adjustment.
The rhetoric from most policymakers suggests to me that they finally realize that the inflation problem is not going to magically resolve itself on its own as the pandemic winds down. That gives me some confidence that the FOMC is willing to do what is necessary to eventually get the job done. Hopefully, it’s not too late already.
MarketWatch: Fed Chairman Jerome Powell is expected to win confirmation today from a key Senate panel for a second term. If you could ask him any one question, what would it be? And what’s the answer you’d like to hear?
Stanley: I would ask him about the wisdom of the 2020 change in the policy framework. In retrospect, that move looks disastrous already, a mere 18 months later.
I doubt that he would admit to it, but I would love to hear from the Fed that they see the wisdom of the Fed’s approach in the Greenspan era, acting pre-emptively when necessary to prevent the economy from overheating rather than pushing the envelope on running the economy hot.