The Federal Reserve will end its meeting any moment with the expected announcement of an accelerated curtailing of the extreme monetary stimulus it has provided since Mar 2020. The latest published speculation I’ve seen is that the Fed will end the stimulus by Mar ’22, paving the way for 2-3 interest rate hikes in 2022, and more in 2023. The Fed’s actions, if not its policy statement, will effectively condemn its previous monetary malpractice. Yesterday we were greeted with the producer price index increase of 9.6% year-over-year, suggesting that consumer prices will continue rising in the future. And much of the price increases real people are seeing are not yet captured in CPI data (specifically the rent increases that will occur as leases are renewed over the next year). The idea of inflation being transitory is likely the one of the Fed’s most irresponsible calls:

Calling inflation “transitory” was a historically bad move for the Federal Reserve, according to Allianz Chief Economic Advisor Mohamed El-Erian.

“The characterization of inflation as transitory is probably the worst inflation call in the history of the Federal Reserve, and it results in a high probability of a policy mistake,” the former Pimco CEO and current Queens’ College president said Sunday on CBS’ “Face the Nation.”

“So, the Fed must quickly, starting this week, regain control of the inflation narrative and regain its own credibility,” he added. “Otherwise, it will become a driver of higher inflation expectations that feed onto themselves.”

Mohamed El-Erian was formerly the director of the PIMCO bond fund, one of the world’s largest funds, which naturally requires a laser-focus on inflation and interest rates. And his economic theory is generally very conventionally Keynesian, yet he is highly critical of the Fed–as he should be. He was joined this week by former Fed Governor Kevin Warsh, who noted:

By August 2020, the Fed had become impatient with the purported low inflation rate of the Ben Bernanke and Janet Yellen years. Chairman Jerome Powell called low inflation—which averaged 1.7% in the prior decade, a mere 0.3 point below the Fed’s target—the pre-eminent economic challenge of our time. So the Fed bet on a new policy regime to get inflation higher. It worked. It’s not the first time a central bank wanted a little more inflation and got a lot more.

Last year, in another break with precedent, the Fed loudly and explicitly endorsed a blowout in federal spending. Congress swiftly agreed. Federal spending increased from an average of about 21% of gross domestic product in the prior decade to more than 30% in fiscal 2020 and 2021. National debt relative to GDP increased from 79% in 2019 to more than 100% today. Most troubling, the Fed bankrolled the fiscal profligacy, purchasing more than half of the new Treasury debt issued this year. Call it monetary dominance.

Mr. Warsh is right on two main points (which regular Bereans have heard me champion multiple times: 1) the Fed’s change to an average inflation targeting regime was a historic mistake, and 2) the Fed has been the enabler of the largest fiscal profligacy in history. Let’s take these one at a time.

Prior to the August 2020 repudiation of sound monetary policy, the Fed had been targeting inflation at 2%. This economist is not a fan of inflation targeting, but if you’re going to do it, the lower # the better. Why not zero?* Yet once they announced the 2% target, the Fed consistently was slightly below it (~1.7% during that decade), leading some to judge the Fed’s policies as failing because we didn’t have enough inflation! The idea of an average inflation target is that if you have say 1% inflation in one period you could allow inflation to be higher the next period, say 3% to meet your goal of 2%. There are innumerable problems with this absurd approach–so let’s count a few. 1) What is the period of time you are considering the average? Why? The Fed studiously avoids discussing this! 2) If you were under 2% for the last decade, do you run over 2% for the next decade? How do you avoid those inflationary expectations not being “baked in” to market psychology? And once baked in, how do you then get back to what you say is good (2%) without throwing the economy into a recession? 3) Once you allow an expansion in inflation, under what basis do you think you can control its rise? So if you were targeting 2% and under-ran that target, and now you want it to go to 3%, how do you propose to tightly control this so we don’t hit 4% instead? But finally, here is the biggest problem of all: average inflation targeting is backward focused, not future focused. You are responding in a reactionary way to things that have happened in the past, and are not acting proactively to anticipate the future. The anecdote describing successful monetary policy is that the job of the central banker is to take away the punch bowl just as the party gets started. The idea is the monetary authorities anticipate what is going to happen if people keep drinking freely at the punch bowl and it won’t end well. But Mr. Powell and the rest of the Board of Governors jettisoned the monetary wisdom so painfully learned from the 20th century and now inflation is alive and well, and most certainly, is not transitory. Worse, and our second point, is that the Fed has been the enabler of the largest expansion of fiscal policy on record–certainly in peace time. But overall, both the private and public sectors have gorged on cheap debt, and there may be tremendous problems servicing that debt should interest rates rise appreciably. As Senator Manchin correctly stated in his op-ed opposing the Build Back Better plan, the debt we’re amassing leaves us little margin to deal with future crises–and future crises we most certainly shall have, even while not knowing what they will look like.

Finally, let’s get to the subject of this blog post. Historically the Fed is almost always too late to raise rates and then they tighten too much, leading to a boom/bust cycle. In the 1970s, we repeatedly went back and forth in this model. As I’ve written previously, our economy is much more acutely vulnerable now to a monetary policy tightening cycle because of the scope of the previous policy ease–there are more business models and ventures that are only even remotely viable when you have easy money. Do I have hope they’ll do the right thing this time? I’d love to hope, except they are already way behind the power curve, only belatedly acknowledging what any shopper can tell you is true. Let’s remember, accelerating the end of the stimulus still means we have three more months of aggressive monetary stimulus while prices are going through the roof. Only in the world of Washington DC does that make sense.

* Actually if I had my way, we’d have a gentle deflation annually consistent with productivity growth–likely ~ 2%/year following George Selgin’s argument in Less than Zero.