Understanding How Inflation Reached a 40-year High

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The United States of America has hit a 40-year high inflation rate following Federal Reserve blunders and decisions made by Chairman Jerome Powell.

After the Federal Open Market Committee declared the 75-basis-point rate increase, stock market investors cheered. However, Powell dampened the markets once again during the post-announcement press conference.

Consumers, companies, and investors are all wondering how the Federal Reserve managed to let inflation surge to a four-decade high. And, as Powell lands himself on the MarketWatch 50’s list of the most influential people, three key reasons have come to light.

Critics Poised Then Pounced

Mohamed El-Erian, the chief economic advisor at Allianz, stated Powell’s insistence that skyrocketing inflation would rapidly dissipate is the “worst inflation call” the Fed has ever made. 

Other market experts likened the current chairman to the former chair, Arthur Burns, who couldn’t rally under political pressure, causing suffocating inflation in the 1970s. 

As an untrained economist, Powell had all eyes on him since the beginning, and the way he will be remembered certainly hangs in the balance.

It could end comparatively well. However, the debate regarding which signs the Fed chose to ignore will continue for decades.

Currently, outside experts, Fed officials, and Powell himself have noted the following three ways inflation managed to reach such a devastating high:

The August 2020 Policy Framework

As the country came out of the major COVID-19 lockdowns, the Fed announced a massive shift — a new policy framework that they wouldn’t let the pandemic stop.

The policy, which the US central bank had been concocting for almost 12 months before the coronavirus, was crafted for a low-inflation world. Thus, it assumed the environment of struggling to get inflation to 2% would continue.

Evidently, the world’s curveballs had other plans. The 20-year-long low-inflation environment did not continue, thwarting the reactionary-based policy shift that caused the Committee to delay the aggressive actions necessary in response to the changing economic climate. 

Fed’s Failure to Keep Up With Ever-Changing Economic Outlook

Powell and his colleagues simply failed to keep up with the rapidly altering economic outlook. They were so set on not overreacting that when confronted with rocketing inflation, they dubbed it a “special event.”

The chief economist at Wrightson ICAP, Lou Crandall, says Powell’s previous position at a private-equity firm has made the Fed chair skeptical of forecasts and economic models.

Ultimately, this led him to switch from the Fed’s tried-and-true forecast-reliance mindset to an outcome-based reaction plan. The result? They flailed for footholds on an in-progress landslide. 

Forward Guidance Gone Rogue

The forward guidance offered to financial markets in 2020 is what has jilted Federal Reserve officials the most. 

Following the 2008 financial crisis, those in bond markets expected the Fed to raise interest rates. However, they gave the market guidance that they weren’t changing course for a while, not raising the benchmark rate until 2016. 

Since the pandemic began, the Fed was purchasing $120 billion in mortgage-backed securities and Treasuries to support the economy while keeping interest rates low.

In September 2020, forward guidance told markets that it wouldn’t raise its benchmark until labor conditions reached levels akin to the maximum employment and inflation had hit 2%.

In December 2020, the Committee gave forward guidance that it would maintain this pace until considerable further progress was made toward price stability and employment goals. 

And with that, market participants thought it was a clear sign that the Fed wouldn’t consider raising rates until 2022. However, that forward guidance proved too restrictive, prompting a rapid cease of bond purchases just a few days before increasing its benchmark rate in March.

While financial storms come with the Federal Reserve territory, Powell doesn’t believe now is a good time to review the policy framework enacted in 2020. 

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