Central banks, 18 months ago got it fundamentally wrong and they got it wrong on many other occasions too.
So why take any notice?
The Fed and other central banks insisted that inflation would be ‘transitory’ – it wasn’t. It reached 7%. That’s 5% above the target of 2%.
Along with the misdiagnosis on prices, Fed officials, according to projections released in March 2022, collectively saw the key interest rate rising to just 2.8% by the end of 2023. It is now 5.25%.
Fed mistakes
The Great Depression
The Fed failed to prevent the collapse of the banking system and the contraction of the money supply in the late 1920s and early 1930s, which worsened the economic downturn and prolonged the recovery. The Fed also raised interest rates in 1931 and 1932, which further depressed economic activity and deflation.
The Great Depression (1929–1939) was an economic bomb that affected countries across the world. It was a period of severe economic depression after a major fall in stock prices in the United States. It began around September 1929 and led to the Wall Street stock market crash on 24th October 1929 (Black Thursday). See Wikipedia article here.
It was the longest, deepest, and most widespread depression of the 20th century.
The Great Inflation
The Fed pursued an overly expansionary monetary policy in the 1960s and 1970s, which fueled high inflation and eroded the value of the dollar. The Fed also underestimated the impact of oil shocks and other supply shocks on inflation and was slow to tighten monetary policy to restore price stability. The Fed eventually raised interest rates sharply in the late 1970s and early 1980s, which triggered a severe recession. And in1991 inflation surged to 8.5%.
The Great Recession
The Fed likely contributed to the build-up of financial imbalances and excessive risk-taking in the 2000s, (Dotcom bubble) – by keeping interest rates too low for too long and by failing to adequately supervise and regulate the financial system.
The Fed also reacted too slowly to the emerging signs of distress in the housing market and the financial sector and was unprepared for the global financial crisis that erupted in 2008. Remember, ‘sub-prime’ lending. We can see signs of similar stress in the U.S. car loan market now.
The Fed had to resort to unconventional monetary policy tools, such as quantitative easing and forward guidance, to stimulate the economy and prevent deflation.
The COVID-19 Pandemic
The Fed and other central banks including the Bank of England initially underestimated the severity and duration of the pandemic and its impact on the economy. The Fed also overestimated the transitory nature of inflation, which surged to a 30-year high in 2021 due to supply chain disruptions, pent-up demand, fiscal stimulus, and base effects. The Fed maintained an ultra-accommodative monetary policy stance for too long, despite mounting evidence of overheating and inflationary pressures.
The Fed finally raised interest rates by 0.75% in December 2022, but faced criticism for being behind the curve and for communicating poorly with the markets.
Transitory inflation
The Fed said inflation would be transitory in 2021 and 2022. The Fed used this term to describe the higher-than-normal prices that emerged during the Covid-19 economic crisis, which were expected to be temporary and not part of a long-term trend. The Fed attributed the inflation surge to factors such as supply chain bottlenecks, pent-up demand, fiscal stimulus, and base effects.
The Fed also said that it would let inflation run above its 2% target for some time, to achieve an average inflation rate of 2% over time. However, as inflation remained high and persistent in 2021 and 2022, the Fed faced criticism for being behind the curve and for communicating poorly with the markets. The Fed eventually raised interest rates.
And now, much of the same. The Fed is again ‘tinkering’ with policy to manage ‘transitory’ inflation and will most probably engineer a recession as a result.
Enough said.