To understand the Q2 2021 inflationary environment — whether it will be sustained or not — it is important to turn to economists. Allan Meltzer, perhaps the most prolific historian when it comes to the Federal Reserve Bank, wrote in the Wall Street Journal: “The Fed’s recent behavior is in sharp contrast to the European Central Bank. The ECB keeps its eye on both objectives, growth and low inflation. It doesn’t shift back and forth from one to the other. The Fed should do the same. In the 1970s, because the Fed shifted from one goal to the other and back again, it achieved neither. Both inflation and unemployment rose on average, then fell together in the 1980s — after the Fed controlled inflation. … After 1985, Fed policy kept inflation and unemployment low. The result was 20 years of growth, and three of the longest peacetime expansions punctuated by short recessions. We should not throw this policy away. Federal Reserve independence is a valuable right which should not be discarded.”
Interesting, right? Well, the quote above is from an Op/Ed in 2008 (forgive us for the slight of hand here). And Dr. Meltzer, after a great career, passed away at age 89 after the last inflationary blip which he wrote about, leaving us with a great body of work on the topic.
The Federal Reserve is a fascinating institution. It has two core components. First, it includes a centralized “Board of Governors” based in our nation’s capital. (Note: This board is designed to be apolitical despite its location.) And second, it includes 12 regional (and autonomous) Federal Reserve Banks located across the country, albeit with greater concentration on the East Coast, in the South and Midwest.
The role of the Federal Reserve — at least its highest visibility role — is to define monetary strategy for the country, including the setting of interest rates that banks can borrow against and loan each other money overnight, also known as the Federal Funds Rate. This is a powerful tool. The setting of higher rates in theory should slow economic growth and curtail inflation; lower rates encourage borrowing and spending to fuel economic growth.
The balance between the two is key, because an overheated economy can lead to inflation and/ or stagflation (a situation in which economic growth and salaries remain stable, but the cost of borrowing and general prices, e.g., those reflected in the Consumer Price Index (CPI), increase — effectively making everyone poorer), while a lackluster economy can lead to a recession or even a depression based on the economy shrinking for a defined period of time.
As noted, the Federal Reserve is supposed to be apolitical, despite three recent member banks wading into opining on progressive economic policies that conservative news outlets quickly described as “woke economics.” But that is a sideshow — a tiny inconsequential one — compared to the situation the Fed is in today in terms of finding itself trying to control massive short-term inflation and unprecedented demand spikes.
Currently, the Fed is describing the inflationary situation with higher consumer prices and spiking raw material inputs (e.g., steel up 400%) as “transitory,” meaning that it does not expect it to be sustained. According to a recent article in The Economist, “the current inflationary spike is clearly rooted in disruptions related to the messy process of reopening, … [and] some economists worry that today’s stimulus-powered growth could lead to a repeat of the errors of the past,” leading to sustained inflation and economic decline.
However, there is no doubt that the Democratic administration will put as much pressure on the Fed as possible — and through legislation — to continue the current economic boom to boost its chances of maintaining control in the midterm 2022 election. But short-term effective economic policy for one political party may be bad economics over a mid-and longer-term horizon if demand and stimulus-driven inflation continues to roar.
Clearly, this will be a test of the Fed to maintain its independence as it navigates a rebound like we have never seen before over such a short period, even in the post-WWII economy. Our money is with the Fed to do the right thing for a sustained recovery, following the history lessons that the late Prof. Meltzer so eloquently chronicled in his history of the Fed across myriad books and papers in his storied career.
