Inflationary threat to the US has only become more real

Last month, in the US, the Fed (Federal reserve bank of the USA) chairman Jerome Powell changed his stance on “transitory inflation,” which he believed was the state of inflation in America, and now claims that inflation is no longer transitory. What does this mean?

What does the phrase transitory inflation mean?

First things first, transitory inflation refers to momentary inflation hikes, which would not make a mark on the economy in the form of higher inflation rates. The Fed chairman claimed that the Quantitative Easing (QE) that the Fed had been doing in order to stimulate the economy after the fallout of the pandemic would not leave a lasting impact on the US economy, thus it would be transitory inflation. Realistically, transitory inflation has little to no negative aspects outside of inflation increasing temporarily. Like an inflationary lump and then the inflation would not be significant in the grand scheme of things and thus not a big issue and the public should not panic and prepare for the worst.

Why did he change his stance on the phrase?

He was forced to change his stance. This is because of the enormous pressure he was under. Initially, this came from economists from the public but soon the data sided with the economists of the public. There was a surge in the employment cost index, which meant that spending of employers was rising faster than expected. Putting pressure on Powell to change the Fed’s stance on inflation. The last nail in the coffin was the surge in CPI (consumer price index, used to measure inflation rates; read 1^st inflation blog for more information) on the 10^th of November which urged him to begin making changes in the Fed, preparing for a hike in interest rates to reduce the inflation rate.

Why was he weary to put increase the interest rates?

This was because as a macroeconomist, the decisions which you make are extraordinarily important. This is because any one of the changes that are made could cause a nation-wide recession. These mistakes are usually in one of 2 ways: the timing of the action being wrong or if the magnitude of the crisis is misjudged.

If the timing of the increased interest rates was early, either the public would experience exaggerated panic and increase the severity of the issue, or the nation would experience a disruption of daily activities (for example, the toilet paper crisis before the fallout of Covid-19). On the other hand, if the timing was too late, the country would experience the effects of inflation.

If the magnitude of the crisis is misjudged, the macroeconomist risks stability by either overcompensating for transitory effects or by undercompensating (and facing inflation without any defences), therefore being unable to stop the crisis. If Powell were to treat a minor inflationary threat with severe actions, it would become incredibly difficult to take out any loans, meaning it would be more difficult for home, business, or car loans to be taken out. Either way the government and the macroeconomist look incompetent.

What will this change mean?

Since the Fed has shown that they know that inflation is a threat, they believe that their counter to inflation will be to hike interest rates 4 times across 2022 by 0.25% as well as beginning QT (Quantitative Tightening) which if significantly different to their previous approach of QE (Quantitative Easing). QE means expanding the Fed’s balance sheets, buying more US treasury bonds and US backed mortgages, and QT is the selling of more US treasuries and US backed mortgages to reduce the balance sheet. This spooked the Bond market and caused it to tank (fall).

If the US government continues these plans, the Bond market will crash. This is because of the Fed being the primary buyer of US bonds, thus boosting their value. QE signals to private investors that there is little to no inflation. If the Fed immediately decides to start selling the bonds, then the bond market will not have enough buyers and thus the market will crash as everyone would be trying to sell their bonds as well as the QT giving the private investors a signal that inflation is coming. As I have said previously in the first “types of investment” blog, high inflation destroys the value of a bond as when the inflation is higher than the yield of the bond, the bond loses value. For example, CPI in the US is nearing 7% and the yield of a US ten-year treasury is just under 1.5% thus the value of the bond decreases.

There is also news for anybody living outside the United States. If the value of the dollar decreases significantly, it means that the trade with the US will be cheaper. Take the UK for example, if the USD declines, one GBP will buy more USD, this means that one GBP will be able to buy more things in the USA than the USA could buy in the UK compared to before. Therefore, in terms of trade, the UK would buy more goods from the US if its currency were inflated. This is quite tricky to get your head around but as a summary: the UK will be able to buy more goods and services from the US, and the US will not be able to buy as many goods and services from the UK.

Finally for the US, things will become more and more expensive if the Fed doesn’t raise interest rates higher to combat the bigger problem of high inflation. This is most likely an issue that the Fed had created over its handling of Covid-19 and its QE measures to help provide the government with stimulus packages under the Biden administration.

 

Thank you for reading my blog, and if you are wondering why there isn’t the “Keynesian school of economics” blog today? The answer is because I thought that this issue was more pressing and would be an important topic to discuss. The “kse” blog will come out on the 28^th.