The Federal Reserve never expected inflation to soar to 7% and hit a 40-year high. Now scrambling central bank leaders insist they’ll do what it takes to snuff out price pressures.
“We will use our tools … to prevent higher inflation from becoming entrenched,” said Jerome Powell, the Fed chairman, in a press conference on Wednesday.
The Fed signaled it’s ready to raise a key short-term interest rate in March for the first time in four years. The bank’s benchmark rate has sat near zero through the entire pandemic.
The bank is also poised to start reducing its nearly $9 trillion stockpile of bonds perhaps as early as the spring.
The Fed gobbled up bonds during the pandemic to drive down long-term interest rates to historic lows. The move made the cost of borrowing for a house, car or business investment very cheap.
All the stimulus from the central bank and federal government, however, had an unwanted side-affect: High inflation.
Low interest rates and a tsunami of extra cash flooding through the economy supercharged customer demand for goods and services beyond the capability of businesses to provide them.
Businesses can’t find enough supplies or labor to keep up, at least not without paying sharply higher prices. And they’ve passed those higher costs onto consumers.
“We understand that higher inflation imposes significant hardship, especially on those least able to meet the higher costs of food housing and transportation,” Powell acknowledged.
In short, too much money has been chasing too few goods — a classic definition of rising inflation. The consumer price index shot up to 7% at the end of 2021 from just 1.4% in the prior year. It’s the fastest increase since 1982.
The Fed never saw it coming.
In December 2020, the central bank predicted inflation would rise less than 2% in 2021. As inflation kept rising, Powell and other senior Fed officials brushed off the increase as “transitory.”
Their argument: Inflation would shoot up briefly as the economy fully reopened, people went about their lives again and there was an explosion in pentup demand. Then inflation would taper off rapidly.
What the Fed missed was the ongoing bottlenecks in supply chains tied to the pandemic. It was hard for businesses to get enough supplies on time or at reasonable prices. And the bottlenecks only got worse due to fresh coronavrus outbreaks and crushing demand.
‘It raises the risk that high inflation will be more persistent,” he said.
Another problem: A surprising labor-market shortage.
Millions of people the Fed expected to go back to work didn’t. Companies were forced to scramble for labor and raise wages. Hourly pay is rising at a 4%-plus yearly pace — the fastest in decades. That’s also adding to the upward pressure on prices.
These problems aren’t going away anytime soon.
The Fed finally recognized the severity of the problem last fall. Powell retired the use of the word ‘transitory” after it became the butt of jokes and senior officials vowed to get inflation under control.
The bank sped up its plan to end its monthly bond purchases and signaled it would raise interest rates several times in 2022. Less than six months ago, the Fed didn’t foresee any rate hikes this year.
“Having been slow to start reining in [asset purchases] and hiking rates, the Fed may have little choice to go with stronger medicine as it tries to put the inflation genie back in the bottle,” said Matthew Sherwood, global economist at the Economist Intelligence Unit.
The accelerated Fed timetable has weighed U.S. stocks early this year after a record-breaking runup. Equities have tumbled in 2022 and market strategists predict a rocky year for stocks.
The trick for the Fed is getting inflation back under control without harming the economy, analysts say.
The Fed itself predicts inflation will slow to 2.6% in 2022, using its preferred PCE price measure. Powell said the supply bottlenecks will eventually go away and the economy will no longer be addled by government stimulus or ultra-low interest rates.
“Our objective is to get inflation back down to 2%,” Powell said.