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Analysis | Never Mind Peak Inflation. Powell Wisely Eyes the Long Term.

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US inflation has been high enough for long enough that the debate about whether price increases have peaked is back in fashion. The question is as misplaced now as it was a few months ago. In reality, signs that inflation will stay too high for comfort mean that the US is probably set for a period of higher interest rates, even if price rises appear to crest. 

Federal Reserve Chair Jerome Powell made that clear Wednesday, when he told the audience at a European Central Bank policy forum in Sintra, Portugal, that the real concern is that the US might be facing sustained higher inflation well above the Fed’s 2% target.

Such conditions take hold when inflation enters the public psyche and becomes self-perpetuating: Workers demand raises to offset higher prices, and companies must raise prices more to offset higher labor costs. This fear will probably keep the central bank aggressive even when it seems as though headline inflation is topping out. As Powell put it:

The clock is kind of running on how long will you remain in a low inflation regime where most of the changes in inflation are actually idiosyncratic as opposed to broadly across the macroeconomy. So the risk is that because of a multiplicity of shocks you transition – you start to transition into a higher inflation regime, and our job is literally to prevent that from happening. And we will prevent that from happening. We will not allow a transition from a low inflation environment into a high inflation environment.

Policy makers keep an eye on inflation assumptions through surveys and other tools, but consumer inflation expectations in particular are exceedingly hard to monitor. And once they show up in the data, it may already be too late. In Powell’s words, “there’s no way to know in real time.” It’s fair to assume, then, that he will err on the side of doing too much to control inflation, even if it seems as if the economy is softening and inflation is falling, provided it is still well above the 2% target.

Even during the inflationary 1970s, prices didn’t go up and up. Instead, there were multiple waves, with the index temporarily bottoming out higher than hoped. This situation was allowed to fester until former Fed Chair Paul Volcker famously crushed inflation with a devastating campaign of higher interest rates that made people so angry that he got death threats.

None of this means that the inflation alarmists will necessarily be proven right. As Powell has repeatedly acknowledged, the current episode is unique in that it continues to have a large supply-side element, and prices for many things could recede as fast as they shot up. There is some evidence that this is already happening in commodities markets.

In the meantime, the Fed is taking a risk-management approach to inflation. For traders eyeing shorter-term bond yields, this would appear to suggest that there is a pretty clear floor on how low yields can go from here unless it becomes evident that inflation has been eviscerated.

Powell, a soft-spoken chair who doesn’t get animated about much, showed his fiery side Wednesday during this exchange about inflation expectations: His wide gaze and gesticulations revealed he meant it when he talked about preventing inflation expectations from becoming embedded. A student of history, he is intent on not being remembered as another Arthur Burns, who chaired the Fed through much of the 1970s and failed to tame inflation, leaving the task to Volcker. 

Clearly, there are many reasons to suspect that inflation will slow soon enough, and this would probably mean fewer rate increases — but probably not by much. Powell says he doesn’t want his policies to cause a recession, but he clearly sees the risk of lasting inflation as the greater of two evils. “Certainly there’s a risk” that monetary policy will hurt the economy, Powell said Wednesday. “But I wouldn’t agree that it’s the biggest risk to the economy. I think the bigger mistake to make — let’s put it that way — would be to fail to restore price stability.”

For investors, the bigger mistake would be to ignore that warning, because it sounds as if he means it.

More From Writers at Bloomberg Opinion:

Homebuilders Still Find Plenty of Demand in a Cooling Market: Conor Sen

Inflation Ate Your Free Lunch, But You’re Still Better Off: Allison Schrager

The US Economy Is Headed for a Hard Landing: Bill Dudley

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jonathan Levin has worked as a Bloomberg journalist in Latin America and the U.S., covering finance, markets and M&A. Most recently, he has served as the company’s Miami bureau chief. He is a CFA charterholder.

More stories like this are available on bloomberg.com/opinion

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