Warning lights are flashing—gasoline is up 40%, home prices are surging, the labor market is tight, and supply disruptions are creating shortages. Inflation has doubled to a 13-year high of 5.3%. Unless the Fed scales back monetary stimulus, the economy will move dangerously close to a treadmill of spiraling inflation.
To be clear, since the covid pandemic struck in early 2020 the Fed has done the right thing. It acted quickly in March 2020 to bring interest rates down, rolling out vast amounts of cash. These bold actions calmed financial markets and reassured an anxious public that a health emergency would not drive down living standards.
There is no overstating the danger that was faced. World Bank chief economist Carmen Reinhart looked at the worldwide shutdown and warned of “global depression.” Federal Reserve Chairman Jay Powell called the pandemic “the greatest shock to the economy in living memory.”
The combination of generous government support, working remotely, and covid-fighting vaccines saved the day even as a new variant threatened the recovery that has taken hold.
But now inflation is the new enemy at the gates and the Fed must act to fulfill its mandate of assuring price stability. The obvious first step is scaling back the $120 billion monthly bond-buying program that keeps interest rates exceedingly low.
Speaking in mid-October former treasury secretary and long-time Democrat Larry Summers expressed “very considerable concern” at the ultra-lax monetary policy, surging house prices, and exploding budget deficit. “We’re in more danger than we’ve been during my career of losing control of inflation,” said Summers.
It’s not only monetary stimulus that has fueled excesses. Even without new infrastructure and social spending programs, the government has put $4 trillion of extra money into the economy in just 20 months. Like with monetary stimulus, fiscal stimulus—the 2020 Cares Act, the 2021 American Rescue Act—were useful, perhaps even essential.
But fiscal stimulus beyond the bi-partisan infrastructure bill is unwise and dangerous. The federal budget is grossly out of whack with a deficit equal to 13% of economic output, the second highest since World War II, exceeded only by a 27% gap in 2020. Put simply the United States cannot incur three-trillion-dollar annual budget deficits without undermining global confidence and the exchange value of the dollar.
As to monetary stimulus, naysayers should put aside their worry that the 2013 taper tantrum will be repeated. In that episode then Chairman Ben Bernanke’s mere mention of scaling back an earlier round of bond buying triggered a sharp but temporary rise in interest rates and a stock market sell off.
Equities lost 5.6% over five weeks but then rebounded—and this is often overlooked—rising 19% with the Standard and Poor’s index ending the year with a 32% gain.
Similarly, when the taper tantrum began the yield on a 10-year treasury was under 2%. It rose to 3% as tapering got underway in 2014 and then fell back to 2.4% when bond buying stopped in October.
The stock market is currently on a tear with prices at record highs. Since the March 2009 great recession low to today the Standard and Poor’s 500 index is up 415%! A modest health-restoring correction associated with an end to artificially low interest rates would be welcomed by many investors.
Jim Grant, the savvy publisher of Grants Interest Rate Monitor, rightfully observes that we currently have the easiest monetary policy in a generation, one that fans the flames of an incipient enduring inflation. Few in Washington hold to the previous Fed maxim that above trend inflation is transitory.
Let us hope that at its November 3d meeting the Fed makes good on suggestions that bond buying is being tapered. Global markets need to hear the message that rates are headed higher and that the United States is determined to forestall inflation as it moves to restore financial stability.
Returning to Larry Summers in mid-October, he referred to the “toxic side effects of quantitative easing” not being recognized by policy makers. There is, said Summers, “a substantial risk that the amount of water being poured in vastly exceeds the size of the bathtub.” #