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The Fed risks a too slow reaction if inflation continues to rise


The global economy is enjoying a strong but mixed recovery. This is what the World Bank released in June Global Economic Prospects tell us. The main reason for recovery is the success of the vaccine program. The main reason for the difference is the limitations of the vaccine program. Some parts of the global economy may become too hot, while others may be too cold. So, stay alert.

This time is really different: the recession was caused not by the need to rein in hyperinflation, nor by an oil shock, nor by a financial crisis, but by a virus. Now, with the success of vaccine programs, the world is enjoying its strongest recovery from recession since 1945.

This is the good news. The bad news is how uneven the recovery can be. According to the World Economic Outlook, 94 percent of high-income countries will recover their pre-recession GDP per capita within two years. This will be the highest share in a very short period of time after any recession since World War II. But 40 per cent of emerging and developing countries are expected to achieve such an outcome this time around. This would be the lowest share after any post-war recession.

The relative success of high-income countries is due to the scale of their fiscal and monetary responses offer the vaccine. Emerging and developing countries lag far behind in all these respects. QE averaged 15 percent of GDP in high-income countries, compared to 3 percent in emerging and developing countries. Financial support averaged 17 percent in high-income countries, compared to 5 percent in emerging and developing countries. However, half of all low-income countries are in debt distress. According to World Bank President David Malpass, “the pandemic has not only reversed gains in global poverty reduction for the first time in a generation, but has also deepened food insecurity challenges and soared food prices for many millions of people.” cut off foreign aid The budget is in amazingly bad timing.

Graph showing recovery is more prevalent in high-income countries

Given all this, the most important decision for Leaders of the Group of Seven high-income countries This week is funding a sharp acceleration in the supply and distribution of vaccines. This will also benefit donors. The epidemic must be stopped everywhere if people are to be truly safe anywhere.

Among the high-income economies, the most important locomotive for growth is the United States, with its very aggressive monetary and fiscal policies. The Budget proposal from Joe Biden It expects a federal deficit of 16.7 percent of GDP in the current fiscal year (through the end of September) and 7.8 percent next year. at the same time, Most Fed members expect interest rates to remain close to zero until the end of 2023. These policies bring great benefits. But how dangerous is it?

The graph shows that inflation rose very quickly in the 1970s

This has become a topic of great debate. Nor is it a purely local issue. If the Fed is forced to raise interest rates sharply, it will likely cause another severe recession in the United States. Not only would it be bad for America, but it would also be bad for the world, including vulnerable developing countries.

It is this context that makes the debate on inflation particularly relevant. Stephen Roach, who worked at the Federal Reserve in the 1970s, Summon Arthur Burns, the Federal Reserve Chairman who let the inflation genie out of the bottle in the early 1970s. If it is repeated, it will be costly for almost everyone. But is this result really possible? The answer is “yes” – not because of what actually happened, but because of the Fed’s commitments.

The graph shows that central banks in high-income countries are expected to continue to pursue ultra-loose monetary policy

The rise in inflation we are seeing now may be modest and temporary and not affect inflationary expectations, the Fed believes. But the Fed shut itself down in response too slowly, especially given the fiscal expansion. This is because, to quote Richard ClaridaVice President, “We anticipate that it will be appropriate to maintain the federal funds rate in the current target range of 0 to 25 basis points until inflation reaches 2 percent (on an annual basis) and labor market conditions reach levels consistent with the [Federal Open market] Committee assessment of maximum employment.

The chart shows that broadband money growth is slowing down, but it's still very high مرتفع

This is an “outcomes-based” policy as opposed to an “expectations-based” policy. What does that mean in layman’s language? This means that the Fed will continue to pursue ultra-loose monetary policy until employment has actually reached its (unknown) “maximum”. Given the lags between policy and outcomes, this ensures that the limit is crossed. By the time the economy finally reaches the point where the Fed begins to tighten, it will be smoking hot (at the “employment cap”), and inevitably it will become even hotter.

This is what happened in the seventies. In this case, the necessary inflation reduction was postponed until Paul Volcker took over in 1979. The experience was harsh. Given the inevitable gaps between tightening and controlling inflation, the costs are likely to be high again. This does not concern the United States alone. Remember, the Volcker shock caused the Latin American debt crisis. This time around, there’s more debt almost everywhere. A severe monetary tightening may lead to more destruction than then.

The chart shows perceptions of inflation risk are on the rise, but remain moderate

Getting the entire world out of the pandemic crisis is far from a done deal. There is still much to be done in this regard. Moreover, the new monetary policy approach of the world’s most important central bank carries the risk of serious excesses. By only responding to the results, the reaction is sure to be very slow. This probably does not matter, because the expectations remain well established, no matter what happens. I pray that this is the case. The alternative does not bear much thought.

martin.wolf@ft.com

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