EC Will The Fed Keep Inflation Contained?

Inflation has surged recently, raising concern that the US economy faces its biggest threat to pricing stability since the 1970s. The counterargument: inflation is transitory and the recent runup in prices will fade as production bottlenecks linked to the economy’s reopening fade. Even if inflation turns out to be more persistent than some forecasters expect, the Federal Reserve will step in and nip the problem in the bud.

The last defense against higher inflation, not surprisingly, is the central bank. That leaves the critical question: How much confidence should be assigned to presuming that the Fed will adjust monetary policy in a timely fashion if faster inflation is stickier than expected?

Skeptics say that the Fed’s track record on economic forecasting is hardly encouraging. To be fair, it’s not obvious that private economists are any better. Forecasting is hard for everyone, especially about the future.

Regardless, the government’s extraordinary pandemic stimulus threatens to permanently raise inflation, some analysts warn. If so, does the Fed have the tools to cap if not reverse higher inflation? Yes, but that leads to another question: Will the Fed use those tools in a timely manner?

Here’s where the outlook becomes hazy, in part because expectations on this front depend on whether you think the central bank has become overly politicized. One line of worry runs as follows: debt levels (for government and the private sector) have increased sharply in recent years and so higher rates will create burdens that the economy can’t tolerate.

There’s some truth in that concern, although the pushback is that if the Fed tightens policy sufficiently early, any upside inflation surprise will be curtailed and so interest rate hikes will be modest.

There’s also the potential for deploying hawkish Fed rhetoric as a tool to convince the markets that the central bank will remain vigilant on keeping inflation contained. There was a hint of this last week when St. Louis Fed President James Bullard said that rate hikes may begin sooner than expected – comments that triggered a decline in commodities prices and Treasury yields.

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Disclosures: None.

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