By Desmond Lachman

As inflation keeps surprising us on the upside, the optimists keep assuring us that there is no real reason to be concerned. In their view, not only does the Federal Reserve have the will to keep inflation in check, it also has the means to do so. Unfortunately, there are all too many reasons to question this sanguine view on the inflation outlook.

It would be an understatement to say
that the Fed has proved to be a poor inflation forecaster. At the start of this
year, the Fed confidently forecast that the Personal Consumption Expenditure
deflator, its favorite inflation gauge, would increase by 1.8 percent in 2021.
In the event, so far this year this inflation measure has increased by 3.6
percent — well above the Fed’s 2 percent inflation target.

Meanwhile, consumer prices have been
increasing by more than 5 percent and show little sign of slowing. This would
seem to be especially the case since over the past year international oil
prices have approximately doubled and global food prices have increased by 33
percent. Meanwhile, US house prices are now rising by close to 20 percent and
the global supply chain remains broken.

It would also be an understatement to
say that the Fed has been irresponsive to building inflationary pressures.
Indeed, at a time that inflation well exceeded its expectations and at a time
that the Biden Administration was engaged in the largest peacetime budget
stimulus on record, far from tightening monetary policy conditions, the Fed was
in effect loosening monetary policy conditions.

One way that the Fed has allowed
monetary conditions to become more expansionary has been to keep interest rates
at their zero-bound despite rising inflation. This has resulted in
inflation-adjusted interest rates becoming increasingly negative. Another way
that the Fed has in effect loosened monetary policy conditions has been to fuel
an equity and housing price boom. It has done so first by expanding the size of
its balance sheet by a staggering $4 trillion in the immediate wake of the
pandemic and then by continuing to purchase $120 billion a month in US Treasury
bonds and mortgage-backed securities.

The inflation optimists believe that
when the time comes to rein in inflation, the Fed has the monetary policy room
to do so. In particular, they believe that by winding down its bond buying
program and raising interest rates, the Fed can bring down inflation without unduly
harming economic activity.

A fundamental point that the inflation
optimists seem to be overlooking is that the Fed has in effect created a global
“everything” asset price and credit market bubble by its unusually strong
monetary policy response to the pandemic. It is not only that US equity
valuations are now at lofty levels experienced only once before in the last 100
years or that US housing prices are now increasing at a more rapid rate than
they did in 2006. It is also that risky borrowers, both in the advanced and in
the emerging market economies, have been able to borrow large amounts of money
at very low interest rates that do not nearly compensate for default risk.

The existence today of a global
“everything” asset price and credit market bubble, which is much more pervasive
than was the 2006 US housing and credit market bubble, has to seriously
constrain the Fed’s room for policy maneuver to bring down inflation. In
particular, too rapid a tapering in its bond purchasing program or too abrupt
an increase in interest rates has to run the real risk of bursting the global
everything bubble. If our 2008–2009 experience is any guide, the potential
bursting of today’s asset price and credit market bubbles runs the real risk of
causing financial market and economic dislocation.

All of this would suggest that the
Federal Reserve will be loath to slam on the monetary policy brakes anytime
soon for fear of bursting bubbles. Rather, it is more likely that the Fed will
continue to exercise patience in the hope that somehow inflation will come down
on its own accord. By so doing, the Fed will be setting us up for many more
months of unacceptably high inflation and additional froth in asset price
markets. It will also be setting us up for a hard economic landing when it will
eventually be forced to take decisive monetary policy action to get the
inflation genie back into the bottle.

Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.

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