It is tempting to give America’s Federal Reserve great credit for its recent about-face in tackling inflation. It is equally tempting to give Chinese President Xi Jinping great credit for his stewardship of a rising and strong China. But neither deserves it – and for a similar reason.
That is certainly true of today’s Fed. Yes, the US central bank has now hiked the federal funds rate (FFR) by 75 basis points three times in a row – the sharpest increase in the benchmark policy rate over a four-month period since early 1982. Predictably, many politicians and pundits are howling in protest, warning of the risks of overkill. I disagree. It was past time for the Fed to start digging itself out of the deepest hole it has ever been in.
My emphasis is on the word “start.” The nominal FFR, now effectively at 3.1%, remains five percentage points below the three-month average of the headline CPI inflation rate of 8%. Notwithstanding the Fed’s newfound determination to arrest a serious outbreak of inflation, it is all but impossible to accomplish that objective with a sharply negative real FFR of around -5%.
Fed Chair Jerome Powell has now conceded that a restrictive monetary policy will be needed to tame inflation. Let’s decode what that means. Based on the headline CPI, the neutral policy rate – basically an average of the real FFR from 1960 to 2021 – is +1.1%. Restrictive, by definition, must be a number greater than neutrality; for the sake of argument, call it a 2% real FFR. With the real FFR at -5%, the Fed is not even close to being neutral, let alone restrictive.
This is where the debate gets tricky: Powell asserted during his September 21 press conference, that Fed policy is now in the lower end of the restrictive zone. He framed that judgment through the lens of underlying inflation measured by the so-called “core personal consumption deflator,” which excludes food and energy. Annual core inflation on this basis was running at 4.6% through July.
This is a disappointing observation for two reasons: The nominal FFR is still well below Powell’s favourite inflation metric, and, more seriously, the Fed’s fixation on core inflation is dangerous. That latter point was true in the early 1970s, when I was part of the Fed’s staff that created the core, and it is also true today.
The very premise of the core is to dismiss major price shocks as transitory, just as Powell initially did. I am still haunted by the “original sin” of my first boss, Fed Chair Arthur Burns, who ignored one transitory shock after another some fifty years ago until it was far too late. The painful lesson: A Fed that lives by the core can die by the core.
For China, the “core” is less about inflation and more about the personal dimension of leadership. Xi Jinping, China’s self-anointed “core leader,” is at the crux of an extraordinary regression in Chinese governance. Unlike the “reform and opening-up” policies that began under Deng Xiaoping over four decades ago, the heavy hand of the Xi-centric Communist Party is now everywhere. That is especially the case with the regulatory assault on internet-platform companies – long the leading edge of China’s dynamic private sector – as well as in the new push toward income and wealth redistribution under the guise of Xi’s “Common Prosperity” campaign.
I stand by my initial assessment of the combined impact of these developments: the emergence of an “animal spirits deficit” that could inhibit Chinese entrepreneurial activity, new startups, indigenous innovation, and productivity. With an ageing China now hitting the demographic wall sooner than most observers, including me, had feared, the lack of a productivity offset is all the more disturbing in constraining the economy’s growth potential. The same can be said for China’s untapped consumers. The animal spirits deficit can only reinforce their concerns about an uncertain future, perpetuating the fear-driven precautionary saving that has long inhibited Chinese consumption.
The Fed’s fixation on core inflation and the overreach of China’s core leader have one important feature in common: susceptibility to major policy blunders. To the extent that monetary policymakers continue to be misled by an inflation problem that proves to be more intractable than a focus on core inflation suggests, they and the financial markets are underestimating the ultimate monetary tightening that will be required to return inflation to a 2% target.
I suspect that the nominal FFR may well have to rise into the 5-6% zone to accomplish that task, implying that the Fed may be only about halfway into its inflation-control campaign. That spells recession in the United States in 2023, which comes on top of the downturn already evident in Europe. China, currently in the midst of an unusually sharp slowdown, is unlikely to be an oasis of growth. A global recession next year is all but inevitable.
To the extent that China’s core leader is blinded by a fixation on ideology and control and unprepared for the harsh economic climate that lies ahead, his troubles may be only just beginning. That is an ironic prospect only a few weeks ahead of the 20th Party Congress, which is widely expected to bestow on Xi an unprecedented third five-year term as China’s leader.
Just as a fixation on core inflation can mislead central banks, the power of a core leader is a recipe for misdirected and ultimately unsustainable policies. The very notion of a core lends a false sense of precision to solutions of complex and tough problems. That is true of both inflation targeting and national governance. The core fixation is just as dangerous for America as it is for China – to say nothing of the shared vulnerability that is driving a worrisome and growing conflict between them. – Project Syndicate
• Stephen S Roach, a former chairman of Morgan Stanley Asia, is a faculty member at Yale University and the author of the forthcoming Accidental Conflict: America, China, and the Clash of False Narratives (Yale University Press, November 2022).
Federal Reserve Chair Jerome Powell