Lentral banks are heavily criticized for letting go and “behind” inflation. But this is not the case. Public policy and geopolitics have prevented central bankers from normalizing monetary policy before inflation swoops down on them. Disruptions in Chinese and Russian supply chains have hit hard against the artificial demand created by the checks the Treasury Department sent to Americans.
The leeway for monetary tightening that would not drag the economy into recession is very small, especially since the modest financial restrictions in place are already causing it to lose momentum. In a long-term economic environment characterized by (rising) debt, (aging) demographics and technological disruption (which displaces labor and demand), persistent disinflation is more dangerous than episodic inflation.
In retrospect, it is clear that central banks were pressured by political leadership to delay their normalization measures when the economy was still strong in 2018. When the pandemic hit, the Trump administration and Congress panicked , ordered the Treasury to borrow trillions of dollars to finance direct payments to households. In 2021, the Biden administration reiterated the device. These new issues of securities were bought by the Federal Reserve (Fed), whose balance sheet has grown over the past two years from 4,000 to 9,000 billion dollars. (nine times the level of mid-2008). The consequences were predictable. As Milton Friedman argued, more money chasing an unchanged output of goods and services means higher prices.
Normally, the Fed could raise rates to slow excess demand for the time needed to catch up with the backlog of supply. But, this time, the coincidence of geopolitics and post-pandemic recovery dynamics produced not just a sharp spike in demand, but a lag in supply.
Fortunately, as consumers have spent their stimulus checks, the latest available data suggests inflation is peaking. And it is expected to decline as companies re-establish supply chains. Inflation may soon be a thing of the past.
Recession
However, once the market is prepared for a rate hike, the most immediate danger is that of an excessive tightening of financing conditions. When the Fed sells Treasury securities, it empties the markets of their liquidity at rates higher than its own interest rate policy! Ten-year bonds have already risen from 1.9% to 2.7% over the past month, and we are only at the start of the first sale of the first part of its asset sales!
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