Fed Policy Versus Demand & Supply-Shocks
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The US economy is currently facing a major energy shock, and the Federal Reserve needs to apply strategies designed for supply shocks. Yet, the Federal Reserve appears to be operating under the belief that they are still dealing with the long-term impacts of a demand shock. The projections from the March 17-18 Federal Open Market Committee meeting suggest a long-term forecast of official rates at 3% and inflation at 2%, resulting in a real official interest rate of 1%. In today's world, that projected rate is much too low.
Although demand and supply shocks may share characteristics like job losses and wealth destruction, the primary distinction lies in their impact on inflation. Demand shocks generally result in a significant drop in inflation, whereas supply shocks have the opposite impact, leading to price hikes from production through to distribution and retail, which in turn causes both headline consumer inflation and core inflation to rise.
Before the two demand shocks of the early 2000s (the tech bubble and financial crisis), the Fed maintained a real longer-run official rate of 2%, sometimes reaching as high as 3%. Following the demand shocks, particularly the financial crisis, the Fed maintained very low and even negative real official rates, after factoring in the stimulative impacts of the quantitative easing policy.
However, those economic conditions are now a thing of the past. Currently, with core inflaiton at 3% and managing with a nominal official rate in the low mid-3% range during the initial phases of an energy shock, it places monetary policy in a precarious situation, as it increases the risk of prolonged higher inflation. Policymakers aim to avoid the policy errors made after the COVID supply shock, but the political climate might leave them with no alternative.
Therefore, it should come as no surprise that the bond market is sensing more inflation.
Joseph G. Carson
AuthorMore in Author Profile »Joseph G. Carson, Former Director of Global Economic Research, Alliance Bernstein. Joseph G. Carson joined Alliance Bernstein in 2001. He oversaw the Economic Analysis team for Alliance Bernstein Fixed Income and has primary responsibility for the economic and interest-rate analysis of the US. Previously, Carson was chief economist of the Americas for UBS Warburg, where he was primarily responsible for forecasting the US economy and interest rates. From 1996 to 1999, he was chief US economist at Deutsche Bank. While there, Carson was named to the Institutional Investor All-Star Team for Fixed Income and ranked as one of Best Analysts and Economists by The Global Investor Fixed Income Survey. He began his professional career in 1977 as a staff economist for the chief economist’s office in the US Department of Commerce, where he was designated the department’s representative at the Council on Wage and Price Stability during President Carter’s voluntary wage and price guidelines program. In 1979, Carson joined General Motors as an analyst. He held a variety of roles at GM, including chief forecaster for North America and chief analyst in charge of production recommendations for the Truck Group. From 1981 to 1986, Carson served as vice president and senior economist for the Capital Markets Economics Group at Merrill Lynch. In 1986, he joined Chemical Bank; he later became its chief economist. From 1992 to 1996, Carson served as chief economist at Dean Witter, where he sat on the investment-policy and stock-selection committees. He received his BA and MA from Youngstown State University and did his PhD coursework at George Washington University. Honorary Doctorate Degree, Business Administration Youngstown State University 2016. Location: New York.
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