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Will the Fed Be Able to Maneuver a Soft Economic Landing?

U.S inflation is now at 40-year highs. The latest data (June, 2022) showed the Consumer Price index (CPI) increased at a 9.1 percent annual rate and U.S. real-GDP declined at a 1.5 percent annual rate in the first quarter of 2022.
In addition,  the U.S. stock market has moved sharply lower, supply-side constraints from COVID dislocations continue, and many believe that the U.S. is already in a recession. So let’s examine how the Federal Reserve Bank got us into this new, multi-faceted policy mess.
The Fed was created to maintain an elastic currency and price stability. It’s job is to provide liquidity needs during emergencies and then backout and let the market find its new equilibrium following economic shocks. 
Fed policy objectives later expanded to include employment goals. These objectives themselves are challenging and can be conflicting. But, following the financial crisis in 2008, the Fed expanded its participation in financial markets by engaging in a massive program of buying assets from financial intermediaries and then holding these assets in the Fed’s portfolio. 
The Fed continued this asset-buying program after the crisis was over and the economy had started to recover.  By paying interest on reserves, the Fed created incentives for banks to hold excess reserves rather than extending credit. 
Now, with the COVID stimulus packages, Biden’s infrastructure package, and other pending fiscal policy initiatives, the Fed is under considerable pressure to help finance the Treasury securities that are being issued to pay for these federal spending programs by printing new money. Moreover, in August 2020, Fed officials adopted a new strategy for monitoring and controlling inflation that probably contributed to their delayed reaction to rising prices in 2021. 

The new approach is called “flexible average inflation targeting” (FAIT). Under this approach, rather than establishing a target rate for inflation, the new strategy allows inflation to rise above its long-run target long enough to make up for past below-target rates of inflation. 
A key problem with this new approach to inflation targeting is that Fed officials never specified the time period over which they would try to smooth inflation rates. Since the Fed can never predict future rates of inflation with certainty, Fed officials can never be sure whether or not they are on an accurate path of correction, thereby increasing the chance of delaying needed policy actions.
The chance of avoiding a recession is much lower now than if the Fed had started responding to rising prices in 2021 rather than explaining away the price pressures as transitory. Once again, the Fed’s timing “to take away the punch bowl” before the economy gets sucked into destructive headwinds was painfully flawed.


Today's PolicyByte was written by Dr. Genie Short. Dr. Short is retired from Southern Methodist University where she taught economics for 17 years. Prior to her teaching career, she spent more than two decades in the banking industry, including 16 years at the Federal Reserve Bank of Dallas. She currently serves on the IPI Board of Directors.