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HSBC economist critiques Fed's inflation strategy

HSBC economist critiques Fed's inflation strategy

The Federal Reserve is making a similar mistake to the one it made after the global financial crisis, according to HSBC economist Albert Edwards. Despite the rise in the US CPI inflation, some inflation indicators show significant deflation. This discrepancy is a major problem and a symptom that the Fed is responding to factors beyond its control. Edwards argues that the central bank’s current actions echo past errors, leading to imbalances in the economy that the Fed cannot effectively manage. This situation highlights the complexities and challenges faced by the Fed in navigating inflation dynamics.

US CPI inflation has been increasing in recent months. The CPI rate hit a low of 3% in June 2023, but it rose to 3.5% in March 2024 and slightly decreased to 3.4% in April 2024. This trend indicates a fluctuating but generally upward trajectory in consumer prices, suggesting that inflationary pressures are persisting despite various economic measures. The continuous changes in CPI reflect underlying economic conditions that are influenced by multiple factors, including supply chain issues, consumer demand, and monetary policies.

However, the rise in the CPI inflation rate is not the core issue, says Albert Edwards. He believes the Federal Reserve is making a fundamental error in its approach. According to Edwards, the Fed’s focus on achieving a specific inflation target is misguided, as it does not account for the complex nature of inflationary trends. He argues that by concentrating on CPI alone, the Fed might be overlooking other critical indicators and factors that contribute to the overall economic health. This narrow focus could lead to policy decisions that exacerbate economic imbalances rather than mitigating them.

"I believe the Fed is sowing the seeds of another policy disaster. They've let the cat out of the bag with the notion of 'transitory' inflation," said Edwards. He suggests that the Fed’s initial dismissal of inflationary pressures as temporary has undermined its credibility. By labeling inflation as transitory, the Fed may have underestimated the persistence of price increases, leading to inadequate policy responses. This misjudgment can have long-term consequences, as persistent inflation erodes purchasing power and economic stability.

The Fed now seems determined to restore its credibility by bringing CPI inflation back down to its target of 2%. This has led to a significant discrepancy between the inflation of goods and services. The central bank’s aggressive stance on reducing CPI inflation has created a situation where different sectors of the economy are experiencing divergent inflationary trends. Goods inflation might be subdued or even deflationary, while services inflation remains elevated. This divergence complicates the Fed’s policy-making, as it needs to balance between different inflationary pressures without harming economic growth.

"This policy error mirrors the mistake made by the Fed after the 2008 global financial crisis," noted Edwards. "After losing credibility in its fight against inflation, the Fed is trying to regain its reputation by being seen as tough and bringing the core CPI rate back down to 2%, even though the official target is the core PCE rate." Edwards draws parallels between the current situation and the aftermath of the 2008 crisis, where the Fed’s credibility was also questioned. The emphasis on achieving a specific inflation target, despite using different measures (CPI vs. PCE), shows a potential misalignment in policy objectives and outcomes. This could lead to unintended consequences that might undermine economic stability further.

By the end of 2023, it appeared that the Fed was winning the battle, as the core CPI rate fell below 2% year-over-year (except for the persistent CPI rent component). Both core goods inflation and core services inflation dropped sharply. However, the Fed's victory was short-lived when core services CPI inflation (or "super core" inflation, as the Fed calls it) started to rise again. This indicates that the initial success in reducing core CPI inflation was not sustainable. The rebound in core services inflation highlights the challenges in maintaining consistent policy outcomes and the limitations of focusing solely on headline inflation metrics.

According to Edwards, the rise in core inflation forced the Fed to keep interest rates higher for a longer period. This prolonged tight monetary policy has driven core goods inflation into the deepest deflation in over 20 years, as shown by a striking chart. The extended period of high interest rates aimed at controlling inflation has had the adverse effect of pushing certain sectors into deflation. Core goods experiencing significant deflation indicates that while some inflationary pressures are being managed, others are being exacerbated, leading to economic distortions.

"Yes, deflation, not inflation. If we look at core goods inflation in the US, we are experiencing the largest deflation in years! This is a complete divergence in inflation indicators. On one hand, we have rising CPI inflation, and on the other, significant deflation, which is dangerous for the economy." Edwards emphasizes the gravity of the situation where different parts of the economy are experiencing opposite inflationary trends. Such a divergence can create instability, as sectors facing deflation may struggle with reduced demand and investment, while those experiencing inflation may face increased costs and reduced purchasing power.

Importantly, the Federal Reserve has no control over the rise in services inflation while core goods experience deflation, emphasized Edwards. The Fed's interest rates, its main monetary policy tool, do not affect the price increases in the CPI basket components driving inflation. This highlights the limitations of monetary policy in addressing inflation that is driven by factors outside the control of interest rates. Structural issues, such as supply chain disruptions or sector-specific demand changes, require different policy responses that go beyond traditional monetary tools.

"This year's rise in services inflation is driven by items almost entirely insensitive to higher interest rates. In my view, maintaining a tighter monetary policy for longer is madness. It currently leads to deep deflation in goods to balance out higher services inflation," commented Edwards. He argues that the Fed’s continued reliance on tight monetary policy is not addressing the root causes of inflation in services. Instead, it is creating deflationary pressures in goods, leading to imbalances that can harm overall economic growth and stability.

This is not just a result of current poor Federal Reserve policy. It's also a significant error over the past several decades, Edwards believes. "It's a catastrophic policy mistake by central banks to have maintained very loose monetary policy for 25 years before the pandemic. It was a vain attempt to bring inflation back to the 2% target. In reality, it was lower, and the central bank had no influence over it. This policy error led to a series of speculative bubbles that constantly burst." Edwards criticizes the long-term loose monetary policies that were intended to stimulate growth but instead led to asset bubbles and economic instability. These policies, in his view, failed to achieve their inflation targets and created vulnerabilities in the financial system.

Many economists have criticized the 2% inflation target or any specific value. Former Fed Chairman Paul Volcker, known for successfully ending the inflation spiral in the late 1970s, condemned the Fed's pursuit of a 2% core inflation target in September 2018. Volcker’s criticism underscores the challenges of rigidly adhering to specific inflation targets. He argued that such targets do not account for measurement errors and the complexities of economic dynamics, suggesting that a more flexible approach might be more effective.

Volcker's criticism was straightforward. Measurement errors in determining the prices of goods and services meant that the precise achievement of the 2% target was meaningless. According to Volcker, it was poor policy. Hence, the 2% target is usually interpreted as a range of 1-3%, as is the case in Poland. This broader range allows for more flexibility in responding to economic conditions, reducing the risk of policy missteps that rigid targets can cause. It acknowledges the inherent uncertainties and variations in economic data and conditions.

"Most economists understood that the disinflationary trends keeping core CPI inflation below 2% were beyond the Fed's control," stated Edwards. He highlights the consensus among many economists that certain trends, such as globalization and technological advancements, have naturally kept inflation lower, independent of the Fed’s actions. Recognizing these external factors is crucial for formulating effective monetary policy.

"It doesn't take a genius to see that the current rise in core services inflation is almost entirely beyond the central bank's control and resistant to high interest rates," he added. Edwards points out the obvious limitations of the Fed’s influence over certain types of inflation. Factors driving services inflation, such as labor costs and service sector demand, are not easily managed through interest rate adjustments, necessitating a broader range of policy tools and approaches.

"The bad news is that the Fed still seems to think it can control things beyond its influence. The bank is trying to exert this imaginary control, driving goods prices into unprecedented deflation. It's madness!" concluded Edwards. He warns that the Fed’s continued efforts to control aspects of inflation that are outside its influence are not only ineffective but potentially harmful. This approach risks creating significant economic distortions, such as deflation in goods, which can lead to reduced investment and growth, further complicating the economic recovery.



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