Quantitative Easing

The Fed may react too slowly if inflation continues to rise



The global economy is experiencing a strong but divergent recovery. This is what the World Bank of June Global economic outlook tell us. The main reason for the resumption is the success of the vaccination program. The main reason for the discrepancy is the limitations of the vaccination program. Some parts of the global economy can get too hot, while others are too cold. So, stay alert.

This time it is quite different: the recession was not caused by the need to curb excessive inflation, nor by an oil shock, nor by a financial crisis, but by a virus. Today, with the success of immunization programs, the world is experiencing one of the strongest post-recession recoveries since 1945.

This is the good news. The bad news is how uneven the recovery will be. According to the World Economic Outlook, 94% of high-income countries will regain their pre-recession gross domestic product per capita within two years. This would be the highest share in such a short period after a recession since World War II. But the proportion of emerging and developing countries that should achieve such a result this time should be 40%. This would be the lowest share after a post-war recession.

The relative success of high-income countries is due to the scale of their fiscal and monetary responses and their vaccine deployments. Emerging and developing countries are far behind in all of these respects. QE averaged 15% of GDP in high-income countries, compared to 3% in emerging and developing countries. Budget support averaged 17% in high-income countries, compared to 5% in emerging and developing countries. Even so, half of low-income countries are over-indebted. According to World Bank President David Malpass, “The pandemic has not only reversed the gains in global poverty reduction for the first time in a generation, but has also exacerbated the challenges of food insecurity and rising poverty. food prices for millions of people ”. The UK’s decision to cut its foreign aid budget is breathtaking.

Chart showing recovery much more widespread in high-income countries

In light of all this, the most important decision the leaders of the high-income countries of the G7 must take this week is to fund a sharp acceleration in the supply and distribution of vaccines. This will also benefit donors. The pandemic must be stopped everywhere so that people are truly safe everywhere.

Among the high-income economies, the most important growth engine is the United States, with its very aggressive monetary and fiscal policies. the Joe Biden’s budget proposal forecasts federal deficits of 16.7 percent of GDP for this fiscal year (through September) and 7.8 percent next year. Meanwhile, most Federal Reserve board members expect interest rates to stay close to zero even until the end of 2023. These policies bring great benefits. But how risky are they?

Graph showing that inflation increased very rapidly in the 1970s

This has become a lot of debate. It is not a purely local affair either. If the Fed has to raise rates sharply, it will likely cause another brutal recession in the United States. It would not only be bad for America, but also bad for the world, including vulnerable developing countries.

It is this context that makes the inflation debate particularly important. Stephen Roach, who worked at the Fed in the 1970s, recalled Arthur Burns, the Fed chairman who let the inflation genius out of the bottle in the early 1970s. If it were to be repeated, it would cost nearly everyone dear. But is this result really likely? The answer is “yes”, not because of what has already happened, but because of the Fed’s commitments.

Chart showing central banks of high-income countries should persist in ultra-accommodative monetary policy

The rise in inflation we are seeing now could be both modest and temporary and not affect inflation expectations, as the Fed believes. But the Fed has locked itself in reacting too slowly, especially given the fiscal expansion. This is because, according to the terms of Richard clarida, Vice President, “We believe it will be appropriate to keep the fed funds rate within the current target range of 0 to 25 basis points until inflation reaches 2% (on an annual basis) and that labor market conditions have reached levels consistent with [Federal Open market] Evaluation by the maximum employment committee ”.

Chart showing broad money growth slowing, but still very high

This is a “results-based” policy as opposed to a “forecast-based” policy. What does this mean in secular language? This means that the Fed will persist with ultra-accommodative monetary policy until employment has already reached its (unknowable) “maximum”. Given the lags between policy and results, this ensures overshoot. By the time the economy finally reaches the point where the Fed begins to tighten, it will be hot (at “maximum employment”) and, inevitably, will get hotter.

This is what happened in the 1970s. In this case, the necessary disinflation was postponed until Paul Volcker took office in 1979. The experience was brutal. With the inevitable lags between tightening and controlling inflation, the costs may again be severe. It wouldn’t matter to the United States alone. Remember: the Volcker shock sparked the Latin American debt crisis. This time around, there is a lot more debt almost everywhere. Severe monetary tightening would create even more damage than then.

Chart showing that perceptions of inflation risk are increasing, but remain subdued

Getting the world as a whole out of the pandemic crisis is far from a done deal. Much remains to be done on this subject. In addition, the world’s most important central bank‘s new approach to monetary policy is in danger of being seriously outdated. By responding only to results, it is almost certain that you will react too slowly. It might not matter, as expectations stay set no matter what. I pray that it will. The alternative does not deserve much attention.

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