Fed Chairman Powell Navigates the Inflation Debate

Fed Chairman Powell Navigates the Inflation Debate

The Federal Reserve confers this week, and Mr. Powell is expected to clarify the central bank’s position. He battles internal dissension over how to proceed, and a haywire economic recovery hampered by the Delta variant.

After a decade of low growth and inflation, Federal Reserve Chairman Jerome Powell unveiled a new strategy a year ago in which the central bank would keep interest rates lower for longer.

Reality has dealt Mr. Powell a different and unexpected challenge: the biggest inflation spike in decades. Consumer prices rose 5.4% in July from a year earlier.

Mr. Powell heads into the Kansas City Fed’s annual conference this week at the center of the debate over how long the currently higher inflation will last, and what the Fed should do about it.

He is managing internal disagreement and weathering external criticism, with economic recovery thrown into renewed turmoil by the rise of the Delta variant.

Some central bank officials expect the recent price surges to reverse on their own, allowing the Fed to stick to the approach Mr. Powell outlined a year ago, intended to generate inflation slightly above 2%. Others see dangers that high inflation will persist, requiring the central bank to consider raising interest rates sooner or more aggressively than they had anticipated to force it down.

For now, Mr. Powell is siding with the first camp but stresses the outlook is uncertain given the unprecedented state of the economy. He speaks Friday at the conference, which is being conducted virtually for the second straight year.

The annual gathering has been a staging ground for high drama in the past, including 2008, when officials grappled with a deepening financial crisis, and 2014, when then-European Central Bank president Mario Draghi laid the groundwork for a new bond-buying campaign.

Last year at the meeting, Mr. Powell unfurled the change in the Fed’s approach to inflation, and this year he is expected to clarify the central bank’s position.

At stake is the fate of an economic recovery that has been far stronger than Fed officials forecast, with output exceeding its pre-pandemic level by the spring, but unemployment still higher and jobs far fewer than before the coronavirus prompted large swaths of business and social activity to shut down last year.

If Mr. Powell gets Fed policy right—reversing its easy-money policies at just the right pace—inflation should recede over time, the economy will continue growing and the labor market can fully heal. If he gets it wrong, pulling back too slowly or too quickly, Americans could struggle for years with higher inflation or a sharp economic downturn.

During his 3½ years at the helm of the central bank, he shifted from raising rates to cutting them in 2019, amid a chaotic trade war and frequent criticism from then-President Donald Trump. Last year, he launched the most aggressive response in the central bank’s history to stop a financial panic and avert a depression as the economy shut down. Fed officials cut interest rates to near zero and began large-scale asset purchases to spur economic growth by encouraging Americans to borrow and spend.

Prices of vehicles, travel and commodities plunged steeply at first, then began climbing this spring, as the economy’s reopening accelerated. The Fed had anticipated some rebound, and by April, Mr. Powell was playing down worries about one-time price surges, arguing they would prove transitory.

But prices in the three months that followed rose more rapidly than Fed officials anticipated. Mr. Powell has indicated he still expects price pressures to ebb but is preparing for the possibility they don’t.

“There’s absolutely no sense of panic,” Mr. Powell said at a news conference last month. “My best estimate is this is something that…is really a shock to the economy that we’ll pass through.”

Most economists agree with Mr. Powell that the recent inflation surge is mostly due to temporary factors, such as shortages of supplies like microchips and rental cars, and of workers. But many of them, including at the Fed, failed to anticipate two things that have amplified price pressures and could continue fueling them for longer, officials said in interviews and public remarks.

First, bottlenecks have been more severe than anticipated. New waves of Covid-19 cases around the world due to the Delta variant, along with uneven vaccine distribution, threaten to disrupt supply chains for longer than hoped.

Second, Fed officials didn’t expect Congress and the White House to pump so much federal aid into the economy this year, which supercharged consumer demand as U.S. vaccination rates and business reopenings were taking off. Last December, the outgoing Trump administration and Congress approved $900 billion in new aid. Then in March, President Biden and Congress agreed to a $1.9 trillion assistance package.

Higher inflation that results from supply-chain bottlenecks won’t be a serious problem for the Fed if it eases on its own. But decisions could become thornier if inflation stays high.

When higher inflation results from restricted supply, raising rates doesn’t solve the problem, as the European Central Bank discovered after raising rates in 2008 and 2011 because of higher oil prices. The move curbed demand rather than increasing supply, ultimately worsening economic damage and making inflation too low in the ensuing years.

“There’s a question of whether you want the Fed tightening into a supply-side shock. Destroying demand isn’t the way to do it,” said Diane Swonk, chief economist at accounting firm Grant Thornton.

The Delta variant also threatens to delay a rebound in travel and leisure spending. The Kansas City Fed last week scrapped plans for this week’s conference, the Jackson Hole Economic Policy Symposium, normally conducted in Wyoming’s Grand Teton National Park, to be held in person.

President Biden is weighing whether to offer Mr. Powell a second term, to begin in February. Mr. Biden’s team has said they agree with the Fed’s inflation outlook, but the president will have to make his decision before he knows whether it pans out. “We will keep a careful eye on inflation each month and trust the Fed to take appropriate action if and when it’s needed,” Mr. Biden said this month.

Mr. Powell, who has returned to a mostly empty Fed building for work three or four days a week, faces the immediate task of forging consensus among the Fed’s internal factions over how and when to reverse their easy-money policies. That is proving tricky because officials are still trying to iron out the new approach to inflation he unveiled at Jackson Hole a year ago.

That policy framework aims to halt a decadeslong decline in inflation, which before the pandemic had reached levels that Fed officials deemed too low.

Under the previous approach, the Fed would raise interest rates as unemployment fell to prevent inflation from exceeding 2%. Now, instead, it would hold off lifting rates pre-emptively and allow inflation to rise above 2% to make up for past shortfalls in inflation. But officials never defined just what that would look like.

Part of the current problem is that the new policy framework was designed to address a different challenge from what the Fed now faces. The new framework aimed to push inflation gradually higher by using low interest rates to fuel stronger demand. Now, because of the pandemic, the U.S. economy is facing the biggest supply disruption in recent history, pushing inflation far above the Fed’s target.

That is raising questions over how the Fed should respond if inflation falls somewhat, but not all the way back, to its 2% goal over the next year or two.

One growing group of officials is more nervous about the inflation surge and believes the economy no longer needs the gusher of easy money that has flooded the system over the past 18 months. They want to start winding down the Fed’s asset purchases sooner and more quickly than the others, making room to raise rates earlier if necessary.

Another camp thinks inflation is more likely to ease on its own over time. They worry that if they tighten policy prematurely, they will slow the economy too much, causing inflation to fall below their target again and making it harder to lift it.

Mr. Powell falls somewhere in between. He has brushed aside talk of raising rates, but during his tenure he has often adopted a “risk-management” approach that preserves the Fed’s ability to shift course if the outlook changes quickly. Tapering the Fed’s $120 billion a month in purchases of Treasury and mortgage securities sooner or faster than previously anticipated would provide such flexibility.

Officials have pledged to continue that buying until the economy gets closer to the Fed’s inflation and unemployment goals.

Core prices, which exclude volatile food and energy costs, rose 3.5% in June from a year earlier, according to the Fed’s preferred gauge, the personal-consumption expenditures price index. That was the highest rate in 30 years. Rising prices over the April-to-June quarter largely reflected disrupted supply chains, temporary shortages and a rebound in travel.

The drivers of those price gains may be fading, recent evidence suggests. Used car prices in July have risen 42% over the previous year, but they rose just 0.2% from June. Airfares rose 19% over the past year, but they declined 0.1% in July from June. In June, categories that make up 8% of the core price basket were responsible for more than 60% of price increases that month.

While inflation has surged in other countries, the increase in the U.S. has been in part because of greater fiscal support, economists say.

Through the first few months of 2021, Mr. Powell urged his colleagues to not talk about withdrawing easy money to demonstrate their commitment to the new framework and to avoid confusing markets. In March, most Fed officials projected they wouldn’t need to raise rates through 2023.

In April, Fed officials introduced language in their heavily debated postmeeting statement to pre-empt worries about higher inflation numbers by saying they were “largely reflecting transitory factors.”

Some chafed against the Fed’s position. Dallas Fed President Robert Kaplan argued against including the language. “It doesn’t reflect what I’m seeing,” he said in a recent interview. Business contacts have warned him, for example, that shortages of semiconductor chips, an important component in new cars, are going to go on potentially for years because the industry will struggle to keep up with higher demand.

Outside critics also piled on. In the 1950s, then-Fed Chairman William McChesney Martin Jr. quipped that the Fed’s job was to take away the punchbowl when the party was revving up. “Now, the Fed’s doctrine is that it will only remove the punchbowl after it sees some people staggering around drunk,” said Lawrence Summers, the former Treasury secretary to President Bill Clinton, at a May conference.

As the Fed’s June 15-16 meeting approached, the surging inflation numbers made the central bank’s earlier projections less tenable. On the Saturday before that gathering, Mr. Powell was surprised to learn most officials had penciled in at least two rate increases by 2023.

Markets mostly took the new rate projections in stride. But they led some analysts to question whether the Fed was stepping back from its view that inflation pressures would be transitory.

Mr. Powell is betting that more workers will return to the labor market as schools reopen, vaccinations make people less risk-averse and more-generous unemployment benefits expire. That should help ease some price pressures by moderating wage growth.

“Americans want to work, and, and they’ll find their way into the jobs that they want,” he said last month. “It may take some time, though.”

Inflation might stay higher than the Fed expects if wage growth accelerates or if other sectors of the economy that haven’t contributed to stronger prices, like residential rents, rise in the coming year.

St. Louis Fed President James Bullard, in a recent interview, said he thinks the Fed will need to start raising rates next year to tamp down inflation.

When the pandemic hit, it was reasonable to think that it would exacerbate the low-growth, low-inflation world that had preceded it, Mr. Bullard said. Instead, aggressive government support, along with vaccines, boosted economic output above its pre-pandemic level this spring, something that took years after the 2008 recession. “This has turned out to be a very different type of macroeconomic shock than the global financial crisis,” he said.

Boston Fed President Eric Rosengren said he also thinks the Fed needs to begin rethinking its current easy-money stance. He thinks workers in high-contact service industries may be able to demand higher pay if Covid-19 proves more persistent, creating an “upward tilt” to wages and prices. As a result, it is possible “we’re not going to continue to have as difficult a time achieving our 2% inflation target as we did coming out of the financial crisis,” Mr. Rosengren said in an interview.

Others are nervous about overreacting. Chicago Fed President Charles Evans told reporters this month he thinks the pre-pandemic dynamics in which inflation, interest rates and global growth were historically low will eventually reassert themselves. He sees core inflation returning to around 2.1% at the end of next year.

“I know I’m going to be very regretful if we claim victory on averaging 2%, and then we find ourselves in 2023 with about a 1.8% inflation rate sustainable going forward,” he said. “I’m probably more nervous than almost all of my colleagues.”

Nick Timiraos and Paul Kiernan

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