In an earlier piece (The dragon at the doors of the US, November 27), we narrated the background to the surge in inflation in the US since October. What surprised the policymakers most, in particular the US Federal Reserve (Fed), was the rapidity of the rise. In the earlier months, inflation was hovering around 4% or slightly above, but did not disturb the Fed or the White House. It was not considered abnormal or uncontrollable.
Unbeknownst to itself, the Fed was trapped in a set of conflicting objectives. As Reuter’s reported on May 24, “Tension between sticky job markets and rising prices could pose a problem for the US Federal officials who have staked an aggressive monetary policy on the belief they can avoid a conflict between returning US employment to pre-pandemic levels and keeping inflation under control.” The Fed hoped to have them all: strong economy, job growth, stable inflation. It has remained elusive so far.
The package proposed by the Fed, in my view, is a trapease act. With the onset of Omicron and its faster spread in the US, it is too optimistic to expect the pandemic to be over by March. More importantly, it postpones the dreaded taper tantrums to a later date
It was the raging pandemic that was the villain. The economic damage inflicted by the pandemic is yet to be assessed in its entirety. However, it is evident that the lockdowns, trade, supply disruptions, etc., have reduced growth rates across the globe. It is not clear when there would be normalcy or when we would reach pre-pandemic levels. The Fed had to intervene in a massive way to lift the Covid-damaged economy. A study by Brookings (What did the Fed do in response to the COVID-19 crisis?, 17 December 2021) explains how the Fed stepped “in with a broad array of actions to keep credit flowing to limit the economic damage from the pandemic”. By and large, it was the assessment that the Fed “acted decisively and with dispatch to deploy all the tools in its conventional kit and to design, develop and launch within weeks a series of innovative facilities to support the flow of credit to households and business”. The support was through the issue of bonds. While in most other countries credit flows through banks, in the US, it is substantially through the capital market. These operations would have to be stopped if monetary tightening has to be put in place, but that cannot happen unless there is economic recovery.
Even more intractable was the legacy of bonds issued in the wake of the financial crisis of 2008, when the Fed began to adopt unconventional policies or the so-called Quantitative Easing (QE). Bonds were issued for about six trillion dollars. Ben Bernanke, as the then Fed chief, said he would drop dollars from helicopters to revive the US economy. There were doubts whether the QE policies would help the revival of the economy. Scholarly studies by the BIS economists also suggested that those policies would skew asset values and lead to excessive financialisation. More importantly, they argued that the unwinding of the bonds (repurchase) would be difficult and could cause harm to the market. These warnings were ignored. In 2013, when Ben Bernanke hinted that the Fed could commence tapering, it led to tantrums in some emerging markets heavily dependent on short-term capital inflows. When Raghuram Rajan, the then RBI Governor, broached the subject in a meeting at Brookings, Bernanke curtly responded that the Fed was under no obligation to consult with others and would go by its statutory mandates. The reference to this issue has been made at length since the Fed has been under pressure to correct the imbalance in its balance sheet and repurchase the bonds. The Fed is also keen and committed to doing it in a phased manner. Surely, it will be double jeopardy if it is combined with anti-inflation tightening. In short, the Fed’s agenda is getting crowded with conflicting objectives. One can well appreciate Powell’s dilemmas or traps.
There was another issue that was debated and opinion was strongly divided between two teams: Team Transitory and Team Persistent. Many economists including Paul Krugman, the Nobel Laureate and Olivier Blanchard, former IMF Chief Economist, felt that the inflation was temporary and could be tided over with proper policies. Powell himself was of the view for some months that inflation was “transitory.” In his speech at the Jackson Symposium delivered on 27 August 2021, he felt that the underlying global disinflationary factors have not reversed or abated and “will continue to weigh on inflation as the pandemic passes into history”. He referred to the problems the central banks face in distinguishing transitory spikes from more troublesome developments. It was not until November in his testimony to a Congressional Committee that he conceded that inflation in the US was persistent. It was after the Federal Open Market Committee meeting on 14–15 December that the Fed shifted its stance to “Inflation battle, winding down pandemic support and tapering of bonds”.
The package proposed by the Fed has been welcomed by the market and analysts as pragmatic. It proposes faster tapering and tapering to end by March 2022. The rate increases to commence thereafter and is calibrated over four quarters. In my view, it is a trapease act. With the onset of Omicron and its faster spread in the US, it is too optimistic to expect the pandemic to be over by March. More importantly, it postpones the dreaded taper tantrums to a later date. When the taper starts at a faster rate, they would reverberate in the forex markets of emerging economies like India.
Kandaswami Subramanian
Served in the Ministry of Finance, GOI, and retired as Joint Secretary
(subrabhama@gmail.com)