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The Fed Should Be Willing to Cause a Recession

WASHINGTON, DC - OCTOBER 30: Federal Reserve Board Chairman Jerome Powell speaks during a news conference October 30, 2019 in Washington, DC. The Fed announced that it will cut interest rates for the third time this year for quarter point. (Photo by Alex Wong/Getty Images) (Photographer: Alex Wong/Getty Images North America)

Recent news of unexpectedly high inflation — prices rose by 8.3% in the year to August — made the Federal Reserve’s task this week a little easier. It affirmed investors’ belief that monetary tightening still has a way to go, and that the central bank will most likely raise its policy rate by another 75 basis points on Wednesday. The more difficult question is what comes after that.

This week’s expected increase would leave the target range for short-term rates at between 3% and 3.25%. That’s still substantially negative in real terms, even allowing for the fact that core inflation of 6.3% is lower than the headline rate. Although the Fed is reining back its stimulus, monetary policy is not yet pressing strongly down on demand. Such gradual tightening might be prudent — but only if the central bank makes clear that it’s ready to go further as necessary and will do whatever it takes to get inflation back on track.

Up to now, and despite efforts to set matters straight, there’s been some ambiguity about this. In particular, Fed officials led by Chair Jerome Powell have said they hope to stifle inflation without pushing the economy into recession. A worthy goal, to be sure, and not impossible — but if it’s achieved, it will have been more through luck than skill. Getting high inflation under control almost always involves a temporary contraction of output together with higher unemployment. If the Fed is suspected of flinching at this possibility, its task will be harder. And in the end, output and employment would have to fall more.

No doubt, reading the true state of the economy under the current extraordinary conditions is difficult. It’s impossible to say how long supply disturbances will persist. The Fed can’t be precise about the respective contributions of, say, energy-price shocks on the one hand and undue fiscal stimulus on the other. Given all this, nobody should suppose that its job is straightforward.

Still, the central bank can’t afford to equivocate about the need to slow the economy. At 3.7%, the current rate of unemployment is lower than “full employment” ordinarily implies. The demand for workers is still outrunning the available supply, and wages are rising at more than 6% a year. To be sure, incomes aren’t going up as fast as prices. That’s fortunate: If they were, the Fed’s task would be even harder, because a spiral of rising wages and prices would entrench high inflation. Even so, wage growth will need to slow substantially for inflation to gradually settle back at the Fed’s 2% target.

That, in turn, is likely to require short-term interest rates that peak at well over 4% and, unfortunately, a somewhat higher rate of unemployment. The Fed surely understands all this. But it needs to show it understands — and won’t balk at the prospect.

More From Bloomberg Opinion:

• Jerome Powell to the Rest of the World: Drop Dead: Marcus Ashworth

• Inflation’s Terrible, Horrible, No Good, Very Bad Day: John Authers

• The Best-Case Scenario for the Fed’s Inflation Fight Is Dead: Jonathan Levin

The Editors are members of the Bloomberg Opinion editorial board.

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