Is the FOMC Impotent?

Monetary Tools Can’t Fix Today’s Problems

In March 2020 the Federal Reserve was able to use old and new tools to manage the unimaginable – a Pandemic. The Fed stabilized the Treasury bond market and the municipal bond market through its purchases and back stopped government loans to small and medium sized businesses to keep them from going under. The Fed had the capacity to contain the financial and economic fallout in its role of being the lender of last resort. With Jay Powell as Chair, the FOMC did a masterful job in a time of national crisis.

Since the Fed formally adopted its 2.0% inflation target in January 2021, the Fed has spent most of the past decade failing to reach it. There were many reasons why inflation remained so subdued. One of them was China’s entrance to the World Trade Organization in 2001 and especially in the years following the financial crisis. As more jobs were moved from the US to China, wage growth for low skilled jobs in the US stagnated, and the cost of goods imported from China declined. China not only imported toys, clothes, furniture, and washing machines but with those lower cost goods it also imported deflation. This dynamic was beyond the control of the Federal Reserve but it was a headwind for their inflation target.

In August 26, 2020 the FOMC announced that it was adopting ‘Average Inflation Targeting’. In guiding monetary policy the FOMC would no longer react if inflation exceeded 2.0% for a period of time. According to AIT, the FOMC wants inflation to average 2.0% over a complete business cycle, so brief periods of above 2.0% inflation would subsequently be offset by a decline below 2.0% during a recession. In announcing the change Chair Powell called it a ‘robust updating’ of policy and was clearly enthusiastic. “The Fed will not just emphasize actual inflation over forecasted inflation, but will also attempt to push the inflate rate above its 2% target. It’s a whole new ballgame.” As noted last year the FOMC couldn’t have picked a worse time to adopt its new framework since I expected the Pandemic to raise inflation comfortably above the 2.0% target.

The Pandemic created many factors that have contributed to the largest increase in inflation in more than a decade. The first domino was a surge in demand after Congress passed $5.3 trillion in COVID-19 relief in 2020 and in March 2021. Of that total $865 billion were direct payments to individuals and couples filing jointly, and $592 billion in unemployment benefits. Combined these payments totaled $1.457 trillion. These figures don’t include the hundreds of millions paid by states to unemployed workers and the rent and mortgage moratorium.

The majority of Americans who received income transfers were stuck at home and unable to spend money on normal activities. The Savings Rate soared to a record 33.8% in April 2020 and 26.6% in March 2021 after Covid-19 relief programs were passed in March 2020 and March 2021. In the three years leading up to the Pandemic the Savings Rate averaged 7.5% and in September 2021 it was back to 7.5%. Wage growth has accelerated for hourly workers, and especially for lower income workers. This is also making it easier for some workers to pad their savings, although higher inflation is lowering ‘real’ wage growth.