U.S. Fed’s inflation ball-dropping shows the downside of its dual mandate

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Federal Reserve chairman Jerome Powell picked a less-than-ideal moment to announce he was purging the word “transitory” from the central bank’s current lexicon of inflation modifiers.

The U.S. central bank chief’s declaration last week before a congressional committee that “the risk of higher inflation has increased” came just as uncertainty about the economic impact the Omicron variant of the novel coronavirus was sending financial markets into a tizzy. Mr. Powell’s about-face on inflation only contributed to the market rout.

Still, timing aside, the significance of the Fed chairman’s move could not be understated. After months of insisting that rising prices were a “transitory” phenomenon driven primarily by supply-chain bottlenecks, Mr. Powell finally conceded that the Fed had got it wrong. For months, it had overestimated the slack in the U.S. labour market, allowing wage pressures to build and expectations of future inflation to become embedded among investors and consumers.

“I think the word transitory has different meanings to different people. To many, it carries a time – a sense of short-lived. We tend to use it to mean that it won’t leave a permanent mark in the form of higher inflation,” Mr. Powell told the Senate banking committee on Nov. 30. “It’s probably a good time to retire that word and try to explain more clearly what we mean.”

Whether the result of a communications failure or a misreading of labour statistics, it is never a reassuring sign when the world’s top central banker admits an error of this magnitude. The question that now hangs over the global economy is whether Mr. Powell’s U-turn has come soon enough to put the inflation genie back in the bottle without triggering a stock market meltdown or a much longer and damaging recession than last year’s pandemic downturn.

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The Fed could soon accelerate plans to end the aggressive bond-buying, or quantitative easing, program that has seen it more than double its balance sheet – to US$8.65-trillion – since the onset of the pandemic in early 2020. It last month announced it would reduce its monthly purchases of U.S. Treasury bonds to US$105-billion from US$120-billion.

But Mr. Powell’s declaration last week, and Friday’s news that the U.S. unemployment rate tumbled to 4.2 per cent in November, has raised the odds that the Fed will increase its “tapering” efforts after next week’s meeting of U.S. central bank’s 12-member Federal Open Market Committee, with the aim of ending its QE program by March. That would clear the way for the Fed to begin raising interest rates much earlier in 2022 than previously expected.

A somewhat more hawkish Fed would complicate matters for Bank of Canada Governor Tiff Macklem, as he seeks to wind down the bank’s own QE program and begin raising interest rates next year. Mr. Macklem could have to move in advance of the Fed to prevent the Canadian dollar from falling, although buoyant oil prices could also help to support the currency.

The policy U-turn at the Fed, which has a dual mission to control inflation and maximize employment, should serve to undermine the case for expanding the Bank of Canada’s mandate. Finance Minister Chrystia Freeland is set to announce this month whether her government will modify the central bank’s current mandate – which revolves around keeping inflation within the range of 1 per cent to 3 per cent annually – to add a full-employment target. Progressive economists have long been arguing for such a change.

However, the Fed’s experience underscores the trade-off that is involved in a dual mandate. The U.S. central bank maintained its extraordinary monetary stimulus throughout 2021 as it waited for the labour market participation rate to return to its prepandemic level. But hordes of Americans who lost their jobs during the pandemic have been slow to seek new employment or have left the work force for good. By focusing on the participation rate, the Fed appears to have misread the other signs of labour-market tightness that are now feeding inflationary pressures.

If Friday’s release of November’s inflation numbers show U.S. prices rising faster than the 6.2-per-cent annual rate at which they rose in October, Mr. Powell can expect more Republican senators to join those who have already announced they plan to vote against his appointment to a second term at the Fed. U.S. President Joe Biden announced Nov. 22 that he intended to renew Mr. Powell’s mandate, but the U.S. Senate must confirm the nomination.

“Mr. Powell’s Fed has forced millions of American families to choose whether to pay the mortgage, feed their families, fill up their gas tanks, heat their homes or buy Christmas presents,” Arkansas GOP Senator Tom Cotton wrote in a Dec.1 Wall Street Journal op-ed, the day after the Fed chief announced plans to stop calling inflation transitory. “Instead of taking immediate action to address this crisis, the Fed has hidden behind its ‘transitory’ talking point, all while pushing irrelevant woke agendas like climate change and critical race theory.”

Ms. Freeland would be wise to avoid making the Bank of Canada a target for similar criticisms by expanding its mandate to include policy issues outside of its inflation-fighting purview.

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