Bank of America says the Fed is playing with fire by downplaying inflation and needs a new playbook

Published Thu, Oct 21 20216:18 AM EDTUpdated Thu, Oct 21 20217:47 AM EDT

Federal Reserve officials could be placing too much emphasis on the past when trying to guide the U.S. economy into the future, according to a Bank of America analysis. The Fed is effectively "fighting the last war," BofA global economist Ethan Harris said, referencing a term that implies officials are looking over their shoulder at previous economic cycles rather than focusing on the unique qualities of the current one. In this case, the Fed is battling an enemy it hasn't seen in decades: persistent inflation that has been driven by factors unique to the Covid-19 pandemic, including supply chain bottlenecks, uncommonly high demand for goods over services and pervasive labor shortages. But rather than trying to tamp down inflation, the Fed has been encouraging it . The central bank last year adopted a new policy regime in which it will tolerate higher levels of inflation in the interest of promoting full and inclusive employment. That has come after more than a decade of falling short of its 2% goal in a climate of an aging workforce, reduced productivity and greater automation. Harris, though, thinks the Fed is too centered on its failures of the past rather than the issue ahead — that inflation may not be as transitory as the policymakers think . "We have never felt that the last cyclical recovery was a good template for the current recovery," the economist wrote. "There is a growing risk that the Fed is forced to make a major policy pivot sometime in the next two years." Under the current policy outline, the Fed soon will begin slowly tapering the amount of monetary juice it's been providing to the economy through its monthly bond purchases. At some point after that process is completed, it would then begin slowly raising interest rates back to a more normal position. But that relies heavily on keeping inflation in check while unemployment goes down. The Fed has a history of having to backtrack on policy when things don't go according to plan. "History shows that a soft landing is very hard to pull off when the Fed is fighting relatively embedded inflation," Harris said. "Moreover, fighting inflation puts at risk the same less-advantaged workers that benefit most from the economic recovery." Indeed, Fed Chairman Jerome Powell has repeatedly said that interest rate hikes can be used to control inflation. But if the Fed has to move too quickly, it can be disruptive and hurt the people it is targeting through its full and inclusive employment efforts — those at the bottom of the wage scale and belonging to segments of the population such as women and minorities who did not equally share in the last economic boom. On Wednesday, investor Paul Tudor Jones warned that the Fed was headed in the wrong direction on inflation. "We have a Federal Reserve Board that are inflation creators, not inflation fighters. That is a huge, huge thing," Jones said on CNBC's " Squawk Box ." "Clearly, I think we have the most inappropriate monetary policy that we've seen maybe in my lifetime." 'What if this is only the beginning?' In his analysis, Harris said the Fed faces several critical questions it must answer to avoid the potential policy mistake he mentioned. "It's too early for a definitive answer to these questions, but clearly the risks are rising," he said. Among them are whether the rate of natural, or full, employment is higher than it thinks coming off a period when the jobless rate bottomed at 3.5%. Wage inflation brought on by the labor shortage has contributed to the current inflation picture and could raise expectations if the pace continues. "What if some of the recent wage acceleration is not purely due to reopening, but reflects more structural changes in the job market?" Harris wrote. "Recent data is putting a spotlight on these questions." He also said the Fed needs to recognize that inflation expectations are rising, and asked "What if this is only the beginning?" Finally, he noted that the fiscal response has been much more aggressive this time around, with Congress pouring in more than $5 trillion of spending while debating another package aimed at infrastructure. "The current fiscal expansion has been much bigger than in the last cycle," Harris said. "This raises the question: is unusually dovish Fed policy needed to achieve this outcome or are they throwing gasoline on the fire?"

Federal Reserve Chairman Jerome Powell adjusts his tie as he arrives to testify before a Senate Banking, Housing and Urban Affairs Committee hearing on “The Semiannual Monetary Policy Report to the Congress” on Capitol Hill in Washington, July 15, 2021.

Kevin Lamarque | Reuters

Federal Reserve officials could be placing too much emphasis on the past when trying to guide the U.S. economy into the future, according to a Bank of America analysis.