Inflation from enemy to desired friend

Powell spoke at the annual conference of the US central bank (Fed) in Jackson Hole, Wyoming. Deploying all available resources is part of a number of strategy changes by the bank, as we embark on a new era in monetary policy. This new strategy is more focused on employment than before.

The Fed has learned that jobs are very important to ordinary Americans and the American economy. From now on, the bank will focus more on achieving maximum employment, or very low unemployment. According to the bank, just over 4% is the natural level of unemployment in the US. During this period, unemployment in the US is over 10%.

Old law old
The old law is that when unemployment falls below the natural level, inflation results. Wages are rising faster (labor is scarce) and demand for goods and services exceeds supply. However, according to the Fed, this law no longer applies.

What the above means together is that the central bank will keep interest rates at 0% and continue to hoard bonds. Until unemployment drops to approximately 3,5%. The difference between the current unemployment rate and the desired rate is large. Knowing that unemployment is only slowly falling, we can be sure that the Fed will not raise official rates until 2024, if not later.

Used calling minutes
This also applies if inflation unexpectedly rises above what the Fed wants. The inflation chapter in the Fed manual is redacted to allow this. The bank continues to aim for approximately 2% monetary depreciation every year. But allows higher inflation for a while to compensate for the years in which monetary depreciation has been too low. Think of previous mobile subscriptions, where you could carry over unused calling minutes to the next month. For example, if inflation is 0% in one year, the bank has no problem if prices rise by 4% the following year. Not only is the crusade against inflation finally over, the former enemy has now become a desired friend.

What the Fed has done under that guise with the strategy recalibration is to replace temporary justifications for the policies of the past 10 years or more (such as the Great Financial Crisis, the risk of deflation and recently corona) with a structural justification for continuing the policy. The bank essentially gave itself an alibi for a policy aimed at further eroding the purchasing power of the dollar.

Missing the boat on rising prosperity
All of this with the goal of making the American economy grow faster in the future and helping the middle class and low-income people. The Fed rightly concluded that these groups have largely missed the boat of rising prosperity due to globalization and technological progress in recent decades.

The strategy has 2 major flaws and 1 major danger. The first flaw is that the question of how the Fed wants to get things done is conspicuously absent. The bank does not go further than 'we are going to do everything we can'. The fact that she is not more specific gives the impression that the Fed actually has no idea how to push unemployment down and inflation up.

Contradictions in strategy
The other shortcoming of the new Fed strategy is that it contains quite a few contradictions. Take that new calling minutes-like approach to inflation. Announcing that the Fed will now tolerate high inflation for a while to compensate for the years of too low inflation is at odds with the aim of making the middle class and people with low incomes more prosperous. High inflation hits precisely those groups the hardest.

In addition, significantly higher inflation for a while also means lower real wages for that entire period. Lower real wages, in turn, result in less purchasing power and less consumption. Since consumption is the driving force behind the American economy, it pushes economic growth down rather than up.  

Interest charges are going through the roof
In addition, if the Fed says it will knowingly tolerate higher inflation for a long time, which could mean several years. Then you can assume that something like this will eventually become visible in long-term interest rates. But that in turn slows down economic growth or can lead to a long-term and deep recession. In that case, many companies and households see their interest costs go through the roof.  

My conclusion is that the Fed doesn't know anymore either. This is evident from the absence of the question of how the bank wants to achieve this and the aforementioned contradictions in the strategy. Our central bank, the ECB, is also recalibrating its strategy. Since the ECB usually follows the Fed, it is easy to estimate what changes Christine Lagarde will announce next year.