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Why the Fed overstimulated the economy

March 24, 2022
Reading Time: 3 mins read
Why the Fed overstimulated the economy

In recent months, it has become clear that the Federal Reserve’s monetary policy is too expansionary to achieve its policy goals, as the Fed was too slow in ending quantitative easing and raising interest rates. In the fourth quarter of 2021, nominal spending throughout the U.S. economy rose at an annual rate of 14.3 percent, pushing aggregate demand well above the pre-COVID-19 trend line. The rapid growth in spending helped push inflation well above the Fed’s 2 percent target.

So where did the Fed go wrong?

In 2020, the Fed adopted average-inflation targeting (AIT) to avoid the mistakes made during the 2010s, when an insufficiently expansionary Fed policy kept the money supply tight and allowed the economy to stagnate for years, with high unemployment making it especially difficult for younger workers to find jobs. To its credit, the Fed’s much more aggressive approach to the COVID recession did allow for a very fast recovery in the job market. Even with the recent high inflation, the economy is doing situs slot gacor better than in the early 2010s. 

Nonetheless, the Fed could have done even better. Like a general fighting the last war, it has traditionally pivoted too slowly when one problem is addressed and the opposite problem moves to the forefront. Under average-inflation targeting, a bit of overshooting during 2021 was appropriate after the 1.3 percent inflation of 2020. Unfortunately, inflation soared to 5.7 percent in 2021 and looks likely to be far too high again in 2022.

I see at least three reasons for the Fed’s policy mistake.

One was too much focus on closing the so-called “output gap” between actual real GDP and potential GDP, which is exceedingly difficult to estimate. Throughout 2021, employment remained depressed well below pre-COVID levels, suggestive of a weak economy that needed more stimulus. But the large estimated output gap was an illusion. In fact, COVID had sharply reduced slot gacor hari ini labor force participation, leaving employers with increasing difficulty finding workers despite the below normal level of employment. 

Because real output gaps are so difficult to estimate, the Fed should focus on variables such as nominal GDP (NGDP). By that criterion, it was clear by the second half of 2021 that policy was becoming too expansionary. An NGDP growth rate of roughly 4 percent is consistent with the Fed’s 2 percent inflation target. Recently, growth in NGDP situs judi slot terbaik dan terpercaya no 1 has been far above that rate.

That brings us to the second reason for the Fed’s mistake. At a press conference last month, Fed Chair Jerome PowellJerome PowellBiden Fed picks get boost from dozens of economists A new role for central banks post COVID-19? Inflation: Where do we go from here? MORE was asked if the Fed should aim for less than 2 percent inflation after a period of excessively high inflation in order to bring the average back down to the long-term target. Powell…

Read More: Why the Fed overstimulated the economy

Tags: EconomyFedfederal reserveinflationInflation Targetinginterest rateJerome PowellMacroeconomicsMarket monetarismMonetary PolicyMoney supplyNominal income targetOverstimulatedQuantitative easing
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