The Obama era threatens a “shellac” unless the Fed wakes up to inflation

The author is President of Queens’ College, Cambridge and an advisor to Allianz and Gramercy

When I look at the outlook for the economy and markets ahead of the US midterm elections in November 2022, I have a troubling feeling that I may end up seeing a replay of a script from a little over a decade ago.

A transformation agenda for the US economy is at risk again as questions arise for the financial markets as well. Fortunately, there is still time to change the plot, but it is getting late. In addition, the most important and necessary policy adjustments are outside the direct control of the Biden administration.

Like Barack Obama in 2008, President Joe Biden came to the White House with ambitious economic policy proposals. If fully implemented, they would contribute to growth that is not only high and sustainable, but also much more inclusive and sustainable.

But similar to Obama, Biden’s ability to enforce these policies depends on the Democrats’ ability to maintain control of Congress. And just like Obama, the prospects for this goal in the first midterm elections in a year are threatened by a misinterpretation of the economic recovery process.

Obama’s ability to push through his economic agenda, including a series of employment-related measures that would have improved both productivity and labor force participation, was severely and prematurely curtailed by a “damaging blow” in the mid-term election that quickly polarized and crippled Congress

This result was underpinned by a misinterpretation of the economic situation. It took too long for Obama’s economic team to realize that the 2008 financial crisis, rather than a very sharp cyclical shock, had exposed profound structural weaknesses that had built up for years and required continued political attention. This has been a secular rather than a cyclical moment for the economy.

Two of the three “T” principles that guided politics at the time (“timely” and “targeted”) were well formulated and absolutely correct. The third, “temporary”, proved inconsistent with the need to emphasize longer-term efforts to promote inclusive growth.

Rather than just hastening a big bang of policies to hasten an economic recovery, sustained structural efforts have been required to improve the functioning of many parts of the economy. Without this, the feeling of economic alienation and marginalization of certain sections of the population grew, which turned an important part of the electorate against the Democrats.

The problem was not the qualifications and experience of the business team. Rather, it was ways of thinking that had unconsciously become hostage to an economic landscape that had been turned on its head both in the run-up to the financial crisis and after its aftermath.

It therefore took time to realize that the economy was not experiencing a deep V-shaped contraction and recovery, but was facing a “new normal” of excessively low and uneven growth – or what was later referred to as “secular stagnation”.

Biden’s Democratic Party risks following the same path if economic officials, and the Federal Reserve in particular, do not quickly move to a more open stance on the inflationary process of the economy and the policy adjustments required.

As I have argued here and elsewhere for months, the Fed has repeatedly mischaracterized inflation as “temporary”.

Trapped in wrong thinking, it is now also hostage to a “new monetary framework” designed for the old world of aggregate deficit rather than the current reality of supply and labor shortages. As a result, the Fed missed some key monetary policy windows to mitigate the risk of unanchored inflation expectations.

Persistently high inflation would hit the poor particularly hard and unnecessarily undermine economic recovery. It also creates detrimental headwinds for the further implementation of the Biden government‘s economic agenda and may also complicate the much-needed general shift in favor of climate-friendly investment.

Hopefully this week’s reshuffle of the Fed’s leadership team will provide the central bank with an opportunity to reformulate its public view of the inflationary challenge to the economy, as a first step towards a significant acceleration in the decline in its massive asset purchases.

Without this, America faces a new risk of delaying again policies that improve both current and future economic well-being.


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