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How did inflation get out of control ? The role of the FED

Inflation | FED | FOMC | Rates | Jerome Powell | Recession | Macro | Economy

Inflation rates from December 2020 to May 2022

The following article attempts to explain how inflation rates could rise from 1.4% in December 2020 to 8.6% in May 2022 and what role the FED played in this process.

Average inflation targeting

Before discussing the FED's assessment of inflation, it is important to mention one change in the FED's monetary policy. In 2020, the original goal of "the pursuit of an inflation rate at 2 percent" was changed to "averages 2 percent over time". The FED described the rationale for this step as follows:

“… if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. … To prevent this outcome …we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”

Powell on inflation, December 2020

In December 2020, inflation projections for the next few years were below the target inflation rate.

"The median inflation projection from FOMC participants rises from 1.2 percent this year to 1.8 percent next year and reaches 2 percent in 2023."

However, it was already evident at that point that inflation would rise in the coming years as a result of the measures taken. The question here is, what exactly were the measures and for what reason were they taken? Summarized in one sentence "powerful

support to the economy until the recovery is complete".

"In addition, as we noted in today’s policy statement, we will continue to increase our holdings of Treasury securities by at least $80 billion per month and of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward our maximum-employment and price-stability goals. We believe the increase in our balance sheet this year has materially eased financial conditions and is providing substantial support to the economy."

The rationale for the measures taken was, as usual, the objective of maximum-employment and price-stability goals. According to the Fed, these goals had not yet been achieved.

"So “substantial further progress” means what it says. It means we’ll be looking for employment to be substantially closer to assessments of its maximum level and inflation to be substantially closer to our 2 percent longer-run goal before we start making adjustments to our purchases."

It is also interesting to note that, based on the new "average inflation targeting", inflation was targeted to exceed 2% in the short term.

"...we will aim to achieve inflation moderately above 2 percent for some time so that inflation averages 2 percent over time..."

Setting a target inflation of over 2% in the short term with maximum monetary support entails risks, especially since the Fed itself says that there is great uncertainty about future economic developments.

"...the outlook for the economy is extraordinarily uncertain and will depend in large part on the course of the virus..."

The step of average inflation targeting was controversial at the time for several reasons. One issue is that the time horizon over which the average is considered is ambiguous. More importantly, however, is the following fact:

"Irrespective of credibility, averaging inflation over the past is not useful. It is quite extraordinary that the Fed opted to modernise its monetary policy framework and introduced such a level of opacity, when all literature suggests that transparency and clarity, in particular in the policy decision process, is necessary to achieve credibility."

Powell on inflation, March 2021

Around March 2021, the real rise of inflation began. The economy recovered faster than expected due to the massive monetary support, surprising the FED.

"The recovery has progressed more quickly than generally and forecasts from FOMC participants for economic growth this year have been revised up notably since our December summary of economic projections."

The main reasons for the faster recovery of the economy are likely to be the effective vaccination and the monetary support for the economy. We should not forget that this was "the fastest and largest response to any post-war economic downturn, offering fiscal support for households, businesses, healthcare providers, and state and local governments". The consequences of this huge financial support are clearly reflected in the record high personal savings rate.

The Fed saw the strong demand that came with the reopening of businesses only as a short-term driver of inflation. The Fed expected these supply and demand dynamics to lead to transitory inflation.

"Beyond these base effects, we could also see upward pressure on prices if spending rebounds quickly as the economy continues to reopen, particularly if supply belt bottlenecks limit how quickly production can respond in the near term. However, these one-time increases in prices are likely to have only transient effects on inflation."

As it turned out later, the fed was wrong in its assessment and it was precisely this strong demand combined with a shortage of supply due to supply chain bottlenecks that drove inflation.

Powell on inflation, November 2021

It took a long time for the FED to abandon its narrative of transitory inflation. More precisely, until around November 2021.

“We tend to use [transitory] to mean that it won’t leave a permanent mark in the form of higher inflation. I think it’s probably a good time to retire that word and try to explain more clearly what we mean.” Powell, November 2021
“I am ready to retire the word transitory” Yellen, December 2021

The Fed is starting to mention that inflation could become a problem and that now not only the short-term inflation forecasts are elevated.

“We understand that high inflation imposes significant hardship, especially on those least able to meet the higher costs of essentials like food, housing, and transportation"
“The median inflation projection of FOMC participants falls from 5.3 percent this year to 2.6 percent next year; this trajectory is notably higher than projected in September."

The rise in labor costs does not speak in favor of transitory inflation either. Labor is usually a "very sticky" cost factor that is persistent.

Powell on inflation, March 2022

Having been very cautious with its measures for a long time, the FED is now in a dilemma. The strong demand and further Omicron cases in China, which are weighing on the supply side, lead to the fact that inflation has not only risen, but is now also more widespread on different price components. With the Ukraine war, these factors are now joined by sharply rising oil and gas prices. Inflation continues to rise as a result.

“Aggregate demand is strong, and bottlenecks and supply constraints are limiting how quickly production can respond. These supply disruptions have been larger, and longer lasting, than anticipated, exacerbated by waves of the virus here and abroad, and price pressures have spread to a broader range of goods and services. Additionally, higher energy prices are driving up overall inflation. The surge in prices of crude oil and other commodities that resulted from Russia’s invasion of Ukraine will put additional upward pressure on near-term inflation here at home."

The Fed is now in a dilemma: The FED will increasingly need to weigh the need to take the fight to inflation against the risk of plunging the economy into recession. Of course, the FED says that a "soft landing" is possible. Whether this will actually work is highly questionable. The FED has little impact on the supply side and the interest rate hikes could only have a limited effect on inflation.

“Borrowing has not been a major driver of inflation during the current economic cycle, so hiking rates—and making it more expensive to borrow—may have limited effect." - Morgan Stanley

In addition, there is political pressure to fight inflation, which does not make the task any easier.


There are numerous reasons why inflation has gotten out of control. It started with the average inflation targeting, which can encourage short-term overshooting of inflation. This new approach led to a short-term inflation target of over 2% in 2020. Setting a target inflation of over 2% in the short term with maximum monetary support entails risks, especially since the Fed itself says that there is great uncertainty about future economic developments. The underlying supply and demand dynamics (strong consumption after the pandemic with supply bottlenecks) is the main driver of inflation. The FED's misperception that inflation is only transitory has also contributed to the situation. In particular, the extremely loose monetary policy in the assumption that inflation was only transitory as well as the extreme financial aid during the Covid-19 crisis. The sharp rise in oil and gas prices due to the Ukraine war is another factor that has played a significant role in the recent price increases. Whether the FED will manage the soft landing is questionable.


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