EVEN BEFORE the U.S. and world economies have fully emerged from the near-depression induced by the needed public health response to covid-19, a new worry is already coming to the fore: inflation. The idea, broadly, is that the massive $1.9 trillion U.S. fiscal support package, coupled with the Federal Reserve’s aggressive bond-buying and interest-rate cutting, will stimulate the economy beyond what is needed to restore production to pre-pandemic levels, resulting in tight markets for everything from labor to lacrosse sticks — and corresponding price increases.
This is not a fringe view, but a serious one voiced by serious economists such as former treasury secretary Lawrence H. Summers. And yet the people responsible for making sure the United States never again sees inflation on the scale of the 1970s — the Federal Open Market Committee — reject it. The Fed unanimously voted Wednesday to keep monetary policy on its present course, which seeks to boost inflation to the annual target of 2 percent and keep it there, on average, over years, even if it means running above that level for extended periods.
Ordinary citizens can’t possibly be expected to adjudicate this dispute, but we can try to keep it in perspective. The first point to note is that the Fed has strong evidence that near-term inflation expectations are “well-anchored”: Bond indexes show financial markets believe inflation will hit the Fed’s target of 2 percent over five years, more inflation than markets expected in the depths of the 2020 recession, but still slightly less than they foresaw in early 2018. The Fed’s success in lifting inflation sustainably above the current 1.5 percent will help determine whether it is able, eventually, to raise nominal interest rates much beyond zero, thus restoring the latitude it will need to make monetary policy in a more normal manner.
The catch is that some of the structural factors that limited wage and price inflation for the past quarter-century — notably the integration of China into global commerce, and the massive increase in the supply of labor that it created — are not only diminishing but shifting into reverse. If such developments are creating a more inflationary environment than the Fed now estimates, the U.S. central bank’s plans will be disrupted, and it will confront inflation much sooner than it, and the markets, are currently projecting. Once destabilized, inflation expectations have a way of getting out of control — fast.
Recent experience has shown that low inflation is far more compatible with large fiscal deficits and monetary expansion than economists once believed. This, in turn, suggests that the United States can pursue very low unemployment without worrying about price stability. And a tight labor market is a powerful instrument — maybe the most powerful — for ensuring that wage-earners share in a growing economy. On balance, the Fed has good reasons to emphasize those benefits, along with the fact that it has “tools” to deal with unexpected inflation.
There is a fine line between confidence and complacency, though. Everything depends on the Fed’s timely willingness to use its anti-inflation tools, even if it means imposing economic pain. We must hope both that the central bank never faces such a test of independence, and that it passes if it does.