The Fed is in a high-stakes race to catch up to inflation

New York(CNN Business) The Federal Reserve helped save the US economy from Covid. Next up: Rescue America from its first inflation crisis in decades.

While the Fed responded swiftly and forcefully to the emerging pandemic in early 2020, its initial response to inflation was slow and faltering.

The Fed shrugged off inflation last year as "transitory," and decided to keep its foot firmly planted on the easy money gas pedal. That only added more fuel to the fire.

Now, after eight straight months of consumer prices spiking by 5% or more, the Fed is finally in inflation-fighting mode.

Yet the magnitude of the price spikes -- consumer inflation hasn't been this hot since 1982 -- raises a sobering question: Has the Fed already made a serious policy mistake?

At a minimum, the Fed is playing catch-up when it comes to inflation.

"The Fed is behind the curve," Aditya Bhave, senior US and global economist at Bank of America, told CNN. "Wherever you look, you have very strong inflation. It's a worrying picture for the Fed."

The question is not whether the Fed can catch up. It can. The tricky part is catching up to inflation without sinking the recovery or panicking Wall Street.

"We have seen generations of reporters talking about the Fed engineering a soft landing," Danielle DiMartino Booth, a former Fed official who is now CEO of research firm Quill Intelligence, told CNN. "It's always lovely to hear about, but it's never actually happened."

The Fed knows how to stop inflation. But....

History shows the Fed can defeat inflation that is far worse than today's sticker shock. In the early 1980s, the Paul Volcker-led Fed tamed inflation by dramatically raising interest rates.

But there was a serious cost to that. The Fed slammed the brakes so hard that the economy tumbled into recession, dealing a painful blow to Main Street.

"At this point, it's up to the Fed to thread the needle: Slow down the growth in inflation without stopping the [economic] growth," JPMorgan Chase CEO Jamie Dimon said Friday in response to a question from CNN on inflation. "I do have a lot of faith in Jerome Powell."

Still, Dimon conceded there is a chance the Fed will be forced to "raise rates dramatically and slam on the brakes."

"Fed-induced recessions don't have to be terrible. Sometimes they are short and sweet," he said.

Where will inflation land?

The Fed has clearly changed its tune on inflation.

In recent weeks, the Fed has announced plans to end its bond-buying stimulus program, and officials are penciling in the first three interest rate hikes for later this year. Moreover, the Fed is signaling it will move swiftly to shrink its $8 trillion balance sheet.

During his confirmation hearing, Fed Chairman Jerome Powell called high inflation a "severe threat" to the recovery and vowed to get prices under control.

Ian Shepherdson, chief economist at Pantheon Macroeconomics, said inflation is unlikely to peak until March. "The speed of the coming downshift is unclear," Shepherdson wrote in a note to clients.

That last part is key. The central question is not when inflation peaks -- but where it lands once it does. Because if inflation peaks soon but remains elevated, that will be a problem.

"The risks are rising that we land at 3%," Bank of America's Bhave told CNN. "That is why, potentially even with four rate hikes, the Fed might still find itself behind the curve."

Dimon: The Fed could hike seven times this year

Powell repeatedly signaled a willingness during his confirmation hearing to move faster, if needed.

Goldman Sachs and some other Wall Street banks are now calling for four rate hikes this year.

Dimon is taking the over on that, telling analysts on Friday there is a "good chance" of more than four, adding: "It could be six or seven."

Booth, the Quill Intelligence CEO, has no doubt the Fed kept its emergency policies in place for too long.

"They definitely overstayed their welcome. This constitutes a policy error," Booth told CNN.

There is a lot of debate over how much room the Fed has to hike interest rates.

On the one hand, rates are near zero and the US economy entered the Omicron wave from a position of strength. Unemployment is very low, demand for workers is high and economists believe GDP accelerated in the final three months of 2021.

However, economists have been marking down their growth forecasts for early 2022, in part due to Covid.

Retail sales unexpectedly declined between November and December, potentially showing evidence of sticker shock setting in among consumers. High inflation and Covid worries helped drive consumer sentiment down in early January to the second-lowest level of the past decade.

Why freaking out Wall Street matters

The Fed must also keep an eye on the bond market.

Booth pointed to how the yield curve, the difference between short and long-term Treasury rates, has flattened recently.

Investors watch this gauge closely because a protracted yield curve inversion -- where long-term bond yields fall below short-term yields -- has been a reliable warning sign of a looming recession.

That's nowhere near happening now, yet Booth argued the flattening yield curve suggests the Fed may not have that much runway for liftoff from zero rates.

"The Fed will never hike interest rates into an inverted yield curve," Booth said. "That would be purposely putting the US economy into recession, which is a big no-no."

And the Fed doesn't want to spook markets.

A more aggressive pace of rate hikes risks driving stocks down. Stocks have already started this year poorly. And Morgan Stanley strategists said Friday conditions are in place for the S&P 500 to tumble by 10% to 20% in the first half of this year.

While the stock market is not the economy, turmoil on Wall Street would dent confidence among consumers and businesses. And given how much stocks have run up, consumers are very much exposed to a market selloff, which would eat into household wealth.

No one knows how to manage a pandemic economy

Justin Wolfers, professor of public policy and economics at the University of Michigan, doesn't believe the Fed made a policy mistake on inflation.

He pointed to how market-based measures of inflation expectations are not signaling panic and have even cooled off recently. And Wolfers argued that overreacting to inflation by slowing the economy through rate hikes would be costly.

"That risks creating a recession on top of a Covid recession," Wolfers said. "To all those families who have an unemployed mom or dad, explain to them that we don't want the Fed to be behind on inflation."

Still, Wolfers concedes there is immense uncertainty about what comes next.

"We don't have any deep level understanding of how to manage a pandemic economy. The usual textbook goes out the window," he said. "Anyone who tells you they are confident about anything right now is kidding themselves."