How Did the Fed Not Anticipate the Inflation Surge?

The greatest inflation spike in 50 years is upon us. It’s worth noting the complete failure of economists and their models to predict what would happen. The Federal Reserve, which was mandated to maintain stable prices, seemed surprised at their inability to do so.

Inflation surge was not something the Fed could have predicted, and it’s obvious that this is a serious understatement. Raphael Bostic was the Atlanta Fed president on February 8, 2021. He stated, “I really don’t think we will see an increase in inflation that is quite robust over the next twelve months.” Eric Rosengren, the Boston Fed president, echoed these sentiments a few days later. He said that it would surprise him to see broad-based inflation sustain at two percent by 2022.

The saying is that problems usually start at the top. Jerome Powell, Fed Chair, predicted in February 2021 that the target of two percent inflation would take three more years.

The summer of 2021 was a difficult time for inflation to be ignored. Fed officials maintained that the time was not yet right to reverse their temporary policies, as they weren’t directly responsible for inflation. Supply-chain restrictions were identified as the main culprit. We were assured that inflation will be temporary once the problem was solved. Powell testified in June last year to a House subcommittee.

“If you look…at the categories where these prices are really going up, you’ll see that it tends to be areas that are directly affected by the reopening. That’s something that we’ll go through over a period…then be over. This should not affect the inflation process.

Powell echoed the sentiment in Jackson Hole last August. Powell also stated that long-term inflation expectations had moved less than real inflation and near-term expectations. This suggests that both households and businesses believe the current high levels of inflation are temporary.

John Cochrane of the Hoover Institution, an economist, always reminds us that inflation expectations for long term are notoriously inaccurate predictors. Unfortunately, not many people listened and the team called “transitory”.

This label seemed arbitrary since inflation is always temporary. The 1970s inflation ended in the 1980s. It didn’t matter if transitory inflation was for a few weeks or months. As inflation rose, the meaning of the term transitory changed so significantly that Powell declared his retirement on November 30. At that point, the inflation rate had reached an alarming 6.8 percent.

Many non-Fed officials made their own bad predictions based on sophisticated forecasting models and/or expectations—the same expectations Cochrane urged us not to be too complacent about. Many theories exist as to why it is not important. It was caused by a base-effect price increase, supply-chain restraints, a drought in Taiwan—everything but the Fed’s expansionary policies and Congress’ overspending, in part because some of these experts had cheered for these actions all along.

Unperturbed, the same people predict inflation will drop in the second quarter of 2022. Perhaps. Perhaps. But, I am certain that inflationary pressures like the money borrowed and printed over the years has led to an unexpected price rise. There may be more to come. Although inflationary pressures, such as supply and cash constraints, will lessen, this is not enough to stop the flow of money and other fiscal restrictions. The Fed has resisted the call to action until now.

Only a few economists got it right. Larry Summers was the former Treasury Secretary. He warned one year ago that President Joe Biden’s American Rescue Plan would “set off inflationary forces of a type we haven’t seen in a generation.” Olivier Blanchard, the former chief economist of International Monetary Fund, tweeted that he agreed with Summers. The program of 1.9 trillion could cause so much economic overheating that it would be counterproductive.

Others were also included. They were laughed at and the legislation passed.

Everyone makes mistakes. This is a reminder to be more humble. It might be time for us to model more, rather than think less.

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