If ever we needed an independent Fed to navigate us through troubled waters, it has to be now.
If ever we needed an independent Fed to navigate us through troubled waters, it has to be now.
I n setting interest rate policy, the Federal Reserve must always make decisions under conditions of uncertainty. However, when it meets today, the Fed will be confronted with far more than the usual amount of uncertainty. That will likely keep the Fed on hold to give it time to make a more informed decision on what direction monetary policy should take.
There is no shortage of complicating factors. How big will the energy and food price shock be that will hit the U.S. and world economies as a result of the Persian Gulf hostilities? How badly will the war with Iran exacerbate the country’s already parlous public finances? How soon and to what extent will the artificial intelligence revolution upend an already weakening U.S. labor market? Are the stresses now emerging in the private credit market the canary in the coal mine about a looming credit crisis?
Start with the possibility of an energy and food price shock. With inflation already running above the Fed’s inflation target of 2 percent, the last thing that the Fed needs is a spike in gasoline and food prices. Yet that is something that now must be expected given both the closure of the Strait of Hormuz and Iran’s attacks on its Gulf neighbors’ oil facilities. Not only does 20 percent of the world’s oil supply pass through those straits. So too does around one-third of the world’s fertilizer supply, which is so important to world food production.
The IMF estimates that if sustained, a 10 percent increase in the international oil price could add 0.4 percentage points to inflation and subtract 0.1–0.2 percentage points from economic growth. This implies that should oil prices remain at their current level of around $100 a barrel, U.S. inflation could be over 1 percentage point higher than it otherwise would be, while economic growth could be more than half a percentage point lower than it otherwise would be. Add to this an expected spike in food prices, and inflation could move significantly away from the Fed’s target.
A key question facing the Fed now is how long the Strait of Hormuz will be closed and how serious the damage will be to the Gulf countries’ oil facilities. If the Fed knew that the oil supply disruption would be temporary, it would be able to “look through” the oil and food-induced inflation spike and leave interest rate policy unchanged. If, on the other hand, it judged that the damage would be substantial and that oil prices would remain above $100 a barrel for a prolonged period of time, it might need to think about raising interest rates to keep inflation expectations well anchored.
But, in this respect, all the Fed knows is what it doesn’t know.
Even before the war with Iran, the Fed was faced with a government that was expected to run budget deficits of over 6 percent of GDP as far as the eye can see. That would put the country’s public debt in relation to the size of the economy on a path to exceed by 2030 its level at the end of the Second World War. The Fed now has to figure out how much the Iran war might increase the defense budget, both as the direct consequence of the war and as a result of the need to put us in a position to counter Chinese and Russian foreign policy adventurism.
If the Fed judged that any increase in defense spending would be properly financed by tax increases or non-defense spending cuts, the Fed could stick to its present policy course. However, if, as is more likely, it were judged that increased defense spending would cause a further ballooning in the budget deficit, it would need to adopt a more restrictive monetary policy. It would need to do so to allay investor concerns that the U.S. government might try to inflate its way out from under its public debt mountain.
The AI revolution is something that, over the long haul, ought, if it even only goes some way to delivering on its promise, to be expected to help the Fed in its quest for price stability. It might do so by substantially increasing labor productivity and reducing labor demand. However, there is much uncertainty as to how quickly AI could exert downward pressure on inflation and labor demand. If the Fed were sure that AI was to yield early fruits, it could be more relaxed than otherwise about the inflationary pressures coming from the energy price shock and an ever-widening budget deficit. But can it be sure? It’s a question that answers itself.
Over the past few months, troubling signs have been emerging in the $2 trillion private credit market as investors seek to exit a number of large private sector credit funds. Meanwhile, Jamie Dimon, the head of JPMorgan, has been warning that the many years of easy money have encouraged unhealthy lending practices and the build-up of unhealthy leverage in the economy. This all raises yet another major area of uncertainty for the Fed as to what it should be doing now with interest rate policy.
All of this is to say that the U.S. economy is currently being buffeted by a number of major forces, shrouding the outlook with a great deal of uncertainty. In those circumstances, the prudent thing for the Fed to do would be to sit on its hands until greater clarity about those forces emerges. The prudent thing for President Trump to do would be to back off from his relentless attacks on the Fed’s independence. If ever we needed an independent Fed to navigate us through troubled waters, it has to be now.