Fed Powell will aim to win a high-stakes bet in the second quarter
Washington Federal Reserve Chairman Jerome Powell bet last year that ultra-low interest rate policies would help revive an economy that has sunk deep into the recession caused by the pandemic. So far, his bet has mostly paid off.
Growth and employment boomed faster than anyone expected. President Joe Biden, citing his commitment to reducing unemployment, selected him on Monday for another four-year term.
However, Powell’s challenge is far from over. Inflation has jumped to its highest level in three decades, and Powell’s efforts to contain it will be the strongest test of his next term. In doing so, he will also have to contend with additional complications, from the extraordinary nature of the pandemic recovery to the risks of progress on other central banks around the world.
Controlling inflation will be especially difficult because the Fed does not face a traditionally overheated economy. Usually, a central bank can cool off runaway growth, and the risk of high inflation, by raising the benchmark interest rate, which affects other loan rates throughout the economy. Doing so slows down borrowing and spending.
This time, massive government spending on stimulus, unleashing pent-up demand as the economy reopens, and the Fed’s own policies – which have kept their short-term rate near zero since March 2020 – have boosted consumer demand. The increased spending was directed mostly at items such as cars, furniture and electronics. Soaring demand has clogged ports and railroads and hit them with shortages of labor and supply. This combination of factors is not something the Fed can fix.
“This isn’t high inflation in your garden. The Fed always aims for?” said Sarah Bender, a professor of political science at George Washington University who has studied the Federal Reserve.
At the same time, the economy is still 4 million fewer jobs than it was before the pandemic. Under the new policy adopted by the Federal Reserve last year, it is again focused on maximizing employment opportunities. If the Fed miscalculates and keeps rates too low for too long to try to stimulate more job growth, the rate increases could accelerate. The central bank will then have to resort to sharper increases in interest rates to bring down inflation again. That, in turn, would risk causing another recession.
“The year 2022 will undoubtedly be one of the most difficult years for the Fed to get through,” said Claudia Sam, a senior fellow at the Jane Family Institute and a former economist at the Federal Reserve. “They have a very complicated task ahead of them.”
By most measures, the economy has done well this year, although higher prices have undermined Americans’ confidence in it and made it difficult for many families to provide food, fuel and other necessities. On Monday, while introducing Powell and his running mate – Lyle Brainard, a member of the Federal Reserve Board of Governors – Biden declared that the US economy had “transformed from a closed economy to one that leads the world in economic growth.” He praised his own policies as well as those of the Federal Reserve.
The president said, “Things are getting better for American workers. Higher wages, better benefits, more flexible schedules. …Savings are up, home values are up.”
However, consumer prices also rose 6.2% in the 12 months ending in October, the fastest year-over-year jump since 1990. After Powell previously described high inflation as merely “temporary,” he now acknowledges that it could continue even The next stage is general.
Most analysts expect the Fed to raise interest rates at least twice in 2022 to try to rein in inflation, which the Fed wants to average 2% per year over time. But these rate increases will create their own challenges. Under the new framework established by Powell and Brainard among others, the Fed wants maximum “broad and inclusive” employment. This means that it will take into account other data points, such as the unemployment rate for black Americans, rather than just the overall unemployment rate.
However, even if the overall unemployment rate drops below 4% next year – which is 4.6% now – which is close to what many Federal Reserve officials consider full employment, unemployment among African Americans is likely to be much higher, given the racial gap permanent unemployment. Black unemployment is now 7.9%.
Stephanie Aaronson, a former Fed economist who now directs economic studies at the Brookings Institution, noted that the Fed has repeatedly said it wants to keep the economy growing as aggressively as possible, to help disadvantaged workers regain their jobs or earn higher salaries. If the central bank instead starts raising interest rates to stifle inflation, it could block some of those potential gains in employment.
If that happened, Aaronson said, “they would have to say why they hadn’t waited much longer.”
She added that Fed officials may note that high inflation is also hurting low-income workers.
“They can articulate this clearly, but they have to start,” Aronson said.
Joseph Stiglitz, a Columbia University economist and Nobel laureate in economics, has suggested that the Federal Reserve should also consider the global consequences of its policies. For example, the European Central Bank has indicated that it still sees rising inflation as a mostly temporary phenomenon. This suggests that Powell could raise interest rates before the ECB does, especially if it does so in the first half of next year.
“It will lead to an increase in the exchange rate (the dollar) which will reduce our exports, reduce American competitiveness and weaken our economy,” warned Stiglitz, who preferred Brainard as Fed chair.
Associated Press economics writer Paul Wiseman contributed to this report.
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