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Fears are growing in Federal Reserve circles that a mix of ultra-loose monetary policy combined with a surge in the budget deficit will generate an unwanted inflation spike to which the central bank may fail to respond in time, according to MNI interviews with several former staffers.
Vague forward guidance on when the Fed will begin to taper asset purchases and raise interest rates increases the chances of a policy mistake, Dean Cruoshore, a long-time economist at the Federal Reserve Bank of Philadelphia, told MNI, echoing comments from other former officials and a serving Fed economist.
"I am watching the inflation possibilities closely. With hugely expansionary fiscal and monetary policies, how can inflation not rise?" he said. "The Fed has no solid parameters for making decisions and I think it is resorting to pure discretion that is undisciplined by rules."
While Fed Chair Jerome Powell reaffirmed his determination to keep monetary conditions easy for as long as necessary during his post-meeting press conference Wednesday, FOMC members made a slight hawkish shift, with more officials penciling in higher rates for 2023 and four seeing a hike in 2022. St. Louis Fed economist David Andolfatto told MNI last month inflation could spike sooner than expected, and indicated such concerns are percolating among current staffers.
Peter Ireland, a former Richmond Fed economist, said he's worried about the politics of trying to tighten monetary policy next year, which is a midterm election year in the United States. That's especially the case now that the Fed has shifted its framework toward one that aims to overshoot inflation slightly and which defines employment more broadly and inclusively.
"A big challenge will be if we go into an election year and the choice is do you want to err on the side of maybe being too tight to choke off inflation or too loose to keep unemployment on the decline and growth on the rebound," Ireland said. "There will be intense political pressure on the Fed to wait too long, to implement inappropriate removal of monetary stimulus."
As MNI predicted, Powell avoided offering greater specificity at his press conference about what conditions might constitute "substantial further progress" toward the Fed's goals, the criteria outlined for a reduction in the pace of the Fed's USD120 billion bond buys.
But Fed officials have signaled they welcome recent rises in inflation and inflation expectations towards the central bank's 2% target as intended goals of their recent policy stance.
Still, the transition from an economy where Fed policy was the only game in town to one where fiscal authorities have become much more proactive has sharply altered the outlook.
"Looking into the future it's true to rationally say that deficits today send a warning signal of higher inflation in the future," Ireland said.
The Congress passed a USD900 billion fiscal support bill in December and another USD 1.9 trillion package this month, and debate has already begun about a future infrastructure bill.
Some market participants are worried about the notion of fiscal dominance – when the budget deficit becomes too large for the Fed to raise interest rates without hobbling the recovery and government borrowing.
"I think that's a legitimate concern," said Jeffrey Lacker, former Richmond Fed president, in an interview. "We're so far outside the bounds of historical experience with regards to the size of deficits and level of the federal debt. You have to be careful. That kind of situation like 1970, where things kind of unravel -- every time that happens it's different."
He added: "What the record shows is you can get low unemployment for sure without causing a burst of inflation but by the same token you can get a burst of inflation without unemployment being very low -- and that's the scary scenario for the Fed."