American lawmakers have taken a lot of mystery and guesswork out of the Federal Reserve’s interest rate policies. Public disclosure rules and Congressional testimonies now provide the information and the time horizon of a decision process about a fundamental variable driving key economic and political events in the United States.
The interest rate we observe in our everyday lives is also called the nominal interest rate, because it consists of a real interest rate and inflation premium lenders require for their (expected) investment returns.
Here is an example. At this writing, the nominal yield paid on the U.S. Treasury’s benchmark ten-year note is 1.45%. With the actual U.S. inflation rate of 5.4% (the U.S. consumer price increase in the year to September), that means Uncle Sam is now getting billions of dollars from lenders willing to part with their money at a negative interest rate of -3.95%.
Most of the lending is currently done by the Federal Reserve (the Fed, for short), which creates money to buy Treasury’s debt in open markets. The Fed does that now with $120 billions of monthly federal debt purchases. According to last week’s official statements, those purchases will be gradually reduced and phased out by the middle of next year – if a "substantial further progress" is observed on employment and inflation.
Strongly underpinned inflation pressures
That’s very clear: Jobs and price stability -- the centerpiece of the central bank’s charter mandate -- will determine the timing, and the extent, of Fed’s evolving policy changes.
Note that the announced policy course hinges on a critical assumption: The Fed expects that by the middle of next year the U.S. inflation will have receded toward its policy range in an environment of a growing and a reasonably fully employed economy.
On current evidence, that’s an excessively optimistic assumption and an eminently tall order.
The present U.S. inflation dynamics are not encouraging at all. Factors underlying rising cost and price pressures in labor and product markets are strong and will be getting stronger in the months ahead as a result of huge demand stimulation by wildly expansionary monetary and fiscal policies. There are also external shocks of climbing energy prices, compounded by disruptions in some critically important global supply chains.
Here are some numbers to illustrate those points.
Based on the U.S. consumer price index, inflation has accelerated from 1.4% at the beginning of this year to 5.4% last September.
Over the same period, producer prices increased five-fold from 1.6% to 8.6%.
The latest business survey data show that prices last month marked the second-highest reading on record, while remaining on a constant upward trend for the last four-and-a-half years.
There is no inflation without tears
Those strong demand and price patterns are underpinned by a 6.3% growth of inflation-adjusted disposable personal incomes, and an exceptionally high 13.3% households’ savings rate. The labor supply remains very tight, the officially reported unemployment rate has fallen to 4.5%, and wages and salaries are rising at an annual rate of 4.1%.
Predictably, rising jobs and incomes have pushed up household consumption 8.4% in the first three quarters of this year, while residential investments, which reinforce consumer spending on durable goods, soared 13.5%. Those two components of aggregate demand account for three quarters of the U.S. economy.
All that has fired up the economic activity currently growing at an annual rate of 6% -- a pace of advance more than three times above the physical limits to the potential and noninflationary growth rate. That is clearly reflected in U.S. business surveys reporting capacity and price pressures, rising order backlogs, and lengthening supplier deliveries.
On top of that, we have oil prices more than doubling since the beginning of the year, with Saudi Arabia and Russia refusing to increase OPEC+ supplies.
And in that general environment, the U.S. government continues to feed an exceptionally strong fiscal stimulus promptly monetized by the Fed with its zero interest rates.
There is enough here to help the reader evaluate the official argument that inflation will fall back toward the range of policy targets (around 2%) next year, and that the current evidence requires no imminent interest rate increases.
You may wish to note that an apparent implausibility of that claim has set Washington and Wall Street rumor mills on speculations about politically motivated monetary policy decisions. Those “political analysts” are pointing out to all-important Congressional elections in November 2022 and to presidential elections in November 2024. They are also reminding that Mr. Powell’s term of office as Fed’s chairman is up for renewal in February 2022.
I have no particular views on all that, but I could well be missing an important political issue in the economic policy making.
My thinking is that playing politics would be a bad counsel in this case. It’s not an intellectual stretch to conclude that running the economy at a pace that is three times above its physical potential is an unwise bet. Odds of election success are zero in inflation crushed jobs and incomes.