The Federal Reserve’s recognition that inflation is not transitory, that the U.S. labor market is very tight and that priority now must be given to price stability is welcome, if belated. Without this pivot, entrenched inflation followed by a recession would be likely.
There have been few, if any, instances in which inflation has been successfully stabilized without recession. Every U.S. economic expansion between the Korean War and Paul A. Volcker’s slaying of inflation after 1979 ended as the Federal Reserve tried to put the brakes on inflation and the economy skidded into recession. Since Volcker’s victory, there have been no major outbreaks of inflation until this year, and so no need for monetary policy to engineer a soft landing of the kind that the Fed hopes for over the next several years.
The not-very-encouraging history of disinflation efforts suggests that the Fed will need to be both skillful and lucky as it seeks to apply sufficient restraint to cause inflation to come down to its 2 percent target without pushing the economy into recession. Unfortunately, several aspects of the Open Market Committee statement and Powell’s news conference suggest that the Fed may not yet fully grasp either the current economic situation or the implications of current monetary policy.
The Fed forecast calls for inflation to significantly subside even as the economy sustains 3.5 percent unemployment — a development without precedent in U.S. economic history. The Fed believes this even though it regards the sustainable level of unemployment as 4 percent. This only makes sense if the Fed is clinging to the idea that current inflation is transitory and expects it to subside of its own accord.
In fact, there is significant reason to think inflation may accelerate. The consumer price index’s shelter component, which represents one-third of the index, has gone up by less than 4 percent, even as private calculations without exception suggest increases of 10 to 20 percent in rent and home prices. Catch-up is likely. More fundamentally, job vacancies are at record levels and the labor market is still heating up, according to the Fed forecast. This portends acceleration rather than deceleration in labor costs — by far the largest cost for the business sector.
Meanwhile, the pandemic-related bottlenecks central to the transitory argument are exaggerated. Prices for more than 80 percent of goods in the CPI have increased more than 3 percent in the past year. With the economy’s capacity growing 2 percent a year and the Fed’s own forecast calling for 4 percent growth in 2022, price pressures seem more likely to grow than to abate.
This all suggests that policy will need to restrain demand to restore price stability. How much tightening is required? No one knows, and the Fed is right to insist that it will monitor the economy and adjust. We do know, however, that monetary policy is far looser today — in a high-inflation, low-unemployment economy — than it was about a year ago when inflation was below the Fed’s target and unemployment was around 8 percent. With relatively constant nominal interest rates, higher inflation and the expectation of future inflation have led to dramatic reductions in real interest rates over the past year. This is why bubbles are increasingly pervasive in asset markets ranging from crypto to beachfront properties and meme stocks to tech start-ups.
The implication is that restoring monetary policy to a normal posture, let alone to applying restraint to the economy, will require far more than the three quarter-point rate increases the Fed has predicted for next year. This point takes on particular force once it is recognized that, contrary to Powell’s assertion, almost all economists believe there is a lag of about a year between the application of a rate change and its effect. Failure to restore policy neutrality next year means allowing two more years of highly inflationary monetary policy.
All of this suggests that even with its actions this week, the Fed remains well behind the curve in its commitment to fighting inflation. If its statements reflect its convictions, this is a matter of serious concern.
To be fair, though, there is another possibility. Perhaps the Fed’s restraint reflects less conviction about what ultimately will be necessary than a desire to avoid being itself a source of economic shocks. We should hope that what we have seen is just the first part of what will be, if necessary, a more radical policy redirection. Time will tell.