Commentary on Political Economy

Wednesday, 6 April 2022


My inflation warnings have spurred questions. Here are my answers.

Federal Reserve Chair Jerome H. Powell speaks during a news conference in Washington on Sept. 26, 2018. (Susan Walsh/AP)

Inflation might look scary now, but it will come down as labor-force participation rises and supply-chain bottlenecks ease.

First, the question isn’t whether inflation will come down from about 8 percent on the current policy path. It is whether it will come down to an acceptable level. That’s a very different proposition.

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Second, given new bottlenecks associated with the Ukraine war, covid-19 closures in China and rising worker restiveness, it is far from clear that new supply-chain developments will be positive. Team Transitory proved dead wrong through 2021. It may well be wrong in 2022.

Third, the optimists have their macroeconomics wrong. True, more job seekers might restrain wages. But more workers earning and spending raise demand and prices. Only if they add slack to the labor market — raising unemployment, in other words — will extra labor-force participants reduce inflationary pressure. Similar logic applies in product markets. If used-car or gasoline prices come down, consumers will have more to spend on other goods, pushing up their prices.

As Powell claimed in his speech, the Fed has a track record of achieving soft landings. So maybe it will all be okay.

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There is a first time for everything, but over the past 75 years, every time inflation has exceeded 4 percent and unemployment has been below 5 percent, the U.S. economy has gone into recession within two years. Today, inflation is north of 6 percent and unemployment is south of 4 percent.

Second, the three examples that Powell points to all were moments when unemployment exceeded inflation, which is very different from today’s configuration.

Third, those soft-landing successes all followed actions to preempt future inflation pressures, something the Fed ruled out in its unfortunately still operative 2020 framework and operating procedures.

The Fed might be late, but it is now doing what you want and raising rates above neutral levels. Why can’t you be satisfied?

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First, it is not raising real rates above the neutral level. On the Fed’s forecasts, real rates — interest rates adjusted for inflation — will be negative and well below their neutral level for this year and next. On market forecasts, real rates will not reach zero, let alone their neutral level, within the next decade.

Second, suggestions to the contrary are based on “assume a can opener” economics. If one assumes a collapse in inflation, then there will be a sharp increase in real rates. But that is not policy; it is simply assumption.

Third, the Fed has revised its view of interest rates upward this year by less than its projection of inflation. This means it has fallen further behind, not caught up with its problem.

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A footnote: Yes, I’ve seen Paul Krugman’s new theory of only future rates being relevant to spending. I’d remind him of his stricture about inventing new economic theories to fit one’s prejudices, as well as of the decades-long tradition of using real Treasury bill or Fed funds rates to index monetary policy.

With all the social distress in the United States right now, how can you recommend strategies that might increase unemployment, particularly for disadvantaged “last-hired, first-fired” workers?

First, just as a prudent physician’s objective is to maximize a patient’s well-being over time, not his comfort over several days, an economic policymaker’s goal should be to maximize average employment and income over time, not just over the next year. And all evidence indicates that allowing inflation to get out of control leads to a very serious recession.

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Second, there is no stable trade-off between inflation and unemployment. Unsustainable overheating of the economy leads not just to high inflation but to permanently increasing inflation, and therefore to steadily increasing costs of restoring price stability.

Third, there can be no real question but that the American job market is unsustainably hot and in need of restraint. Those who find this conclusion distressing should consider that real wages in the United States have, on average, increased faster when nominal wages were rising at 4 percent rather than at 6 percent.

Long-run inflation expectations have not become unmoored. We can relax until long-term expectations rise.

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First, it seems reasonable to postulate that, to a significant extent, expectations have stayed fairly anchored only because the Fed has belatedly adopted the position of its critics. In just over a year, the Fed has moved from projecting no interest rate increases till 2024 to projecting seven increases this year while accelerating quantitative tightening. Suppose the Fed had stuck with paths proposed by the doves. Where would inflation be now?

Second, if the experience of the 1970s has taught us anything, it is that by the time high inflation expectations are entrenched, it is too late to bring down inflation without a major recession. And there is evidence that adverse expectations are forming. After remaining essentially constant through 2021, five-year inflation expectations beginning a year from now have risen by one-third of a percentage point in 2022.

Third, markets, forecasters and the public are often wrong. For years, expectations ran behind inflation during the 1970s as it went up, then overestimated it during the 1980s as it came down. Experience suggests that there is much momentum in expectations, and they have been moving up of late.

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Shouldn’t the Fed err on the side of expansion given the savage costs of deflation and the impossibility of reducing interest rates below zero?

First, this is a valid argument to a point. Indeed I made it forcefully in opposing rate hikes from 2015 to 2019. Today, though, with high inflation, there is plenty of scope for inflation rates to exceed interest rates if this is necessary to stimulate the economy.

Second, there is an offsetting consideration. In a world where deflationary shocks are always possible, it is important for the Fed to build up its capacity to act. It can do that only by rapidly getting rates meaningfully above zero.

Third, economists often convince themselves that inflation is not that serious a problem. Progressives should consider not just recent public opinion polls but the reality that inflation, and a related sense that things were out of control, did much to elect Richard M. Nixon, Ronald Reagan and Margaret Thatcher.

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It’s easy to be critical. What would you have the Fed do?

First, as part of its new “humble and nimble” approach, the Fed should renounce its 2020 policy framework as not related to current challenges and instead emphasize setting interest rates relative to neutral rates, so as to achieve price stability and maximum employment.

Second, in the current context, this means a determination to achieve a meaningfully positive real short-term interest rate in the relatively near term, as long as no other major financial market dislocations occur.

Third, there is no advantage to delaying rate changes that are almost certain to happen. The Fed should signal openness to half-point increases, or possibly even more, at all meetings.

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