Between a Rock and a Hard Place
Authors & Contributors
Chief Economist & Macro Strategist Vincent Reinhart details the difficult path forward for the Federal Reserve in the face of large-scale inflation and shocks to both global aggregate supply and demand amid the Russia invasion of Ukraine.
1. The Russian invasion of Ukraine poses shocks both to global aggregate supply and aggregate demand.
- The supply shock, as it takes key commodities off the market and further impairs already damaged global supply chains, is probably large and long tailed.
- The demand shock is about lost confidence, income, and wealth.
- Central banks are impotent against the former shock, as their actions do not create extra output to fill in lost supply. As for the latter, they can support aggregate demand by making financial conditions easier.
2. The appropriate policy adjustment depends, however, on the joint consequences of the two shocks. A more significant hit to aggregate supply than to aggregate demand adds to cost pressures, posing opposing threats to a central bank’s goals of price stability and maximum employment.
3. Russia has marginalized itself on the world economy over three decades, relies on major economies, and is only important among near neighbors. So, the supply effects are mostly about the composition of trade, especially Russian energy output that is almost entirely directed to one place—Europe.
4. In addition, Russia and Ukraine are major suppliers of many agricultural commodities, including wheat, corn, and seed oils, which is especially problematic for vulnerable Emerging Market and Developing Economies (EMDEs). Post-pandemic, almost one-third of the global population lives with moderate-to-severe food insecurity. Food and energy price inflation worsens those strains on vulnerable households, as well as the budget position of many EMDEs that provide energy and food subsidies. The combination foments popular unrest (remember Arab Spring).
5. This is a further blow to global trade, which had already been set back by the Great Financial Crisis, the subsequent trade wars, and the pandemic. An impaired international market restricts supply and adds to costs.
6. Inflation is large in scale (near 8 percent in the US), wide in scope (across goods and services in the consumer price index (CPI) basket, some of which have a lot of momentum), and shared by our trading partners globally (two-thirds of which have inflation above 5 percent). The public is worried about the pass-through of rising costs to prices and activity, probably more so than Federal Reserve (Fed) officials.
- In current circumstances, the pass-through of rising costs to inflation might be larger than previously because inflation expectations are less well anchored.
- As opposed to the prior thirty years, inflation is no longer bound in a narrow range around the Fed’s goal of 2 percent, which had been consistent with the Volcker-Greenspan definition of price stability (when households and firms do not worry about price changes in making decisions).
7. If the current adverse shock is more akin to those before the modern era of policy making of the past thirty years, responding to it with modern-era gradualism follows an inappropriate precedent.
- Having broken out of the Volcker-Greenspan zone of price stability, the current upside surprise of inflation is as dramatic as the downside shocks that previously prompted aggressive easing.
- Fed officials should appreciate the need for a significant policy reset in the near term.
- True, recession risks are elevated because output effects may be larger from nonlinear effects of recent large changes in oil prices. A pause later as such risks become manifest will at least start from a more appropriate level for the longer run.
8. Front-loading policy firming now is especially important because the group dynamics of the Federal Open Market Committee (FOMC) will get more complicated.
- The current group is not the set of deciders by the end of the year, given the pending changes at two Reserve Banks and three nominations to the Board of Governors (Senate willing). As Chair Powell builds the case for extending the firming cycle at the turn of the year, he will have fewer fellow travelers.
- Late in the year, policy will have tightened a bit, financial conditions will have followed up, the unemployment rate will be moving sideways, and inflation will have fallen off its peak. The case for an extended pause will be compelling and shared by many policymakers, but that might make it harder to restart.
9. We doubt Fed officials sufficiently share these concerns. As a result, our forecast is that Fed tightening will not return inflation to goal within the next two years.
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