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The Fed has bet on a future of low inflation. Here's what could go wrong - MarketWatch

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The Federal Reserve has bet that high U.S. inflation will fade back to pre-pandemic lows in the next year or so, but if the wager is wrong it could create more hardship for millions of people and even sap an economic recovery.

Read: The U.S. economy shows immunity against delta after early scare

The most immediate threat from high inflation is the erosion in household buying power, economists say. Prices are now rising faster than wages and making it harder for families to meet their needs, especially those on lower incomes.

If inflation remains stubbornly high, the Fed could also be forced to raise interest rates sooner than it planned and risk upsetting a strong economic recovery.

In a worst-case scenario, critics contend, consumers and businesses could come to expect steadily rising prices and make it a self-fulfilling prophecy. Such a broad shift in attitude after a few decades of remarkably stable inflation could make it harder for the Fed to manage the economy in the longer run.

“Once people start to expect inflation to be higher, they change their behavior in ways that make it harder to get inflation to come back down,” said Stephen Stanley, chief economist at Amherst Pierpont Securities.

Soaring inflation

The rate of inflation has more than doubled this year to 4.2% and shot up to the highest level in three decades, using the central bank’s preferred price barometer. Inflation based on the so-called personal consumption expenditures index had averaged just a little above 1.5% a year in the decade before the pandemic.

Central bank officials had insisted for months the increase was all temporary. They blamed Covid-related disruptions in global trade and major changes in consumer buying habits for broad shortages of materials that caused prices to spike.

Th Fed still thinks price pressures will fade, but the central bank now acknowledges inflation could remain above its 2% target for longer than anticipated. Some senior officials are also getting antsy and want to phase out a massive Fed bond-buying program that’s being used to prop up the economy.

The debate took center stage this week at the Fed’s latest two-day meeting to decide its next step. For now the central bank appears to be track to announce plans to taper its bond purchases within the next few months.

Read: With Fed officials split over outlook, Powell seeks to find compromise tapering plan

Pandemic-driven inflation

The Fed is right that the pandemic has played a key role in the surge in inflation this year. Take autos. A global shortage of computers chips has curbed production of new cars and trucks and contributed to buying frenzy for used vehicles.

The result: Prices of new and used cars have climbed to record highs in 2021 and contributed heavily to the increase in U.S. inflation.

The problem is, price increases have spread to a broad array of business supplies and filtered through the broader economy. Companies are increasingly trying to recoup these costs by charging customers more for their products and services.

What’s more, shortages and production bottlenecks linked to the pandemic are still acute and are unlikely to relent anytime soon, keeping upward pressure on inflation.

Rising wages

What’s also adding to the cost of doing business are higher wages. Average hourly pay has risen at a sharp 4.2% pace over the past year.

Millions of people left the labor force early in the pandemic and haven’t returned, creating the worst labor shortage in arguably decades. Companies have to pay more to retain current employees or to attract new ones, especially at businesses like restaurants where workers are more reluctant to deal face to face with customers like they once did.

All these factors raise the question of whether inflation will fall as quickly as the Fed has predicted. The Fed itself predicts inflation will drop to 2.1% in 2022 from an estimated 3.4% in 2022.

Yet the Fed also got inflation quite wrong this year. Just 10 months ago, the central bank prediction inflation would increase a tepid 1.8% in 2021. The Fed has since doubled its forecast.

Wall Street economists don’t think inflation will fall as quickly as the Fed believes. Most predict prices will rise at least 3% in 2022.

“That is my worry,” said chief economist Richard Moody of Regions Financial. “Inflation will be above the Fed’s [2%] target through all of next year.”

Damage to the economy

A prolonged bout of high inflation could cause consumer spending — the main driver of the U.S. economy — to slow. Consumers have already cut back on purchases of new cars and other goods because of record prices. A recent survey found that consumers say it’s the worst time to buy a car since the early 1980s.

What could also pose a risk to the economy is if the Fed moves to squelch inflation by raising interest rates more rapidly than it plans. A series of rapid interest-rate hikes could choke off U.S. economic growth and sent stock markets plummeting.

“That could rattle financial markets and the economy,” said senior economist Sal Guatieri of BMO Capital Markets.

Read: Why China’s Evergrande crisis isn’t a big problem for the U.S. economy

Yet the likelihood of the Powell Fed acting so aggressively appears dim, other analysts say. The central bank is more focused on ensuring a strong U.S. jobs market and low unemployment and less worried about a sustained period of high inflation.

Stanley of Amherst Pierpont believes the Fed will raise interest rates slowly even if inflation remains elevated, possibly making it harder for the central bank to put the genie back in the bottle.

The big risk, he said, is that consumers and businesses lose faith in the Fed’s ability to keep inflation low. Such an outcome could make the U.S. economy more unstable and prone to sharper ups and downs.

Farfetched? For now Wall Street appears to think so.

The stock market has skyrocketed over the past year and bond yields have remained extremely low, suggesting investors don’t believe the Fed will let inflation get out of hand. Chairman Jerome Powell has repeatedly insisted the Fed has the tools and the determination to make sure it doesn’t happen.

“People have confidence the Fed will do the right thing at the end of the day,” Stanley said. “I hope that confidence is well placed.”

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