Consider the links in this chain of macroeconomic challenges:
First, an economy that even progressives such as Paul Krugman recognize as overheating is operating with a core inflation rate close to 7% and not yet declining – the latest monthly figure exceeding the latest quarterly figure, which at its turn exceeds the last annual figure.
Second, the combination of the adverse effects of inflation and the adverse effects of necessary anti-inflationary policies has led to a consensus forecast of a recession beginning in 2023. The Federal Reserve’s latest projection suggesting that inflation can be brought down at 2% without unemployment rising above 4.4% is simply not a plausible forecast.
Third, the Fed has raised interest rates in ways markets would have thought unlikely to the extreme just a year ago. Markets are reeling from shock, with the possibility that normal trading could collapse in the Treasuries market, an event which, if left unchecked, would have significant ramifications for other markets .
Fourth, the global economy is being tested everywhere by rising US interest rates and a dollar exchange rate at record highs against some key currencies. The fallout from the war in Ukraine has also been devastating for many economies. A weak and closed global economy is hurting our exporters and our markets and dangerously jeopardizing vital national security interests.
And all this while we are still figuring out our way around covid-19, the cases of which are likely to increase this winter. It is estimated that more than a million workers have been taken out of work by a long covid. Additionally, the effects of covid appear to be slowing productivity growth in the United States, with productivity actually declining so far this year.
Each of these problems could be consuming in normal times. How should policy makers respond to the combination of all of this?
Inflation first
The objective of the policy should at least be clear. What is most important is that the maximum number of Americans who want to work can work with as high an income as possible, now and in the future. Other issues – from the level of public debt to the functioning of financial markets to trade incentives for inflation – are not important in themselves but because of their effects over time on employment and income.
In other words: questions of macroeconomic policy are not about values but about judgments about the ultimate effects of various actions. As Fed Chairman in the early 1980s, Paul Volcker is famous for taming runaway inflation at the cost of a severe recession. But he did so not because he cared less about unemployment or workers’ incomes than his predecessors, but because he rightly recognized that a delay in bringing inflation under control would only complicate things.
This principle is found in the current labor market. Even as job openings have reached unprecedented levels and labor shortages have empowered workers, real incomes for Americans have fallen dramatically. Unless inflation comes down, working people will not see a significant increase in their purchasing power – and many will continue to doubt the government’s ability to do the basics.
That is why it is vital that the Federal Reserve does not waver. President Jerome H. Powell has pledged to impose monetary policy tight enough to bring inflation back within the range of the Fed’s 2% target. The more confident workers, businesses and markets are that the Fed will follow through on this, the less painful the process will be.
From this perspective, the Biden administration (unlike some in Congress) was right to avoid publicly pressuring the Fed. Such pressure should be seen as counterproductive, even by those who are most alarmed at the dangers posed by aggressive Fed action. The pressure is unlikely to lead to lower interest rates in the near term – the Fed is more likely to harden its spine to avoid appearing to have bowed to political pressure – while the markets would react to it with higher risk premia and rising inflation expectations. Putting pressure on the Fed can only hurt the economy.
The idea that the economy has overheated, and therefore that monetary policy must be restrictive, is finally widely accepted even by the cronies of the “transitional team”. But those who initially argued that inflation would be short-lived are now starting from two valid points – that monetary policy is working with lags and recession risks are rising – to the problematic conclusion that the Fed has done enough to contain inflation and risks causing an excessive slowdown with further tightening.
Of course, the Fed will have to carefully judge when it can be confident that the economy is on its way back to sustainable price stability. Private sector housing and some other data suggesting that inflation should decline in 2023 are encouraging but do not yet provide a basis for this confidence.
However, it is a basic error to say that since inflation expectations seem contained, the Fed can relax. Expectations are contained only because the Fed’s tightening has been much more aggressive than expected. And today’s expectations are conditioned by the assumption that interest rates will rise almost two percentage points from current levels.
Those who think the Fed is about to do enough should explain their point of view. If they think that interest rates above 4%, in an economy with core inflation of 7%, will cause a recession severe enough to reduce inflation below the Fed’s 2% target, they must explain why. I find that absurd. Perhaps the argument is that preventing too deep a recession is so important that it is worth abandoning the Fed’s inflation target. But proponents of this view need to explain how, if inflation stays well above 2%, we can avoid continued erosion of real wages down the road.
For more than a decade, from 1966 to 1979, policymakers failed to do what was necessary to contain inflation because they balked at the immediate consequences of restrictive policy. History remembers it badly. Conversely, I know of no instance in which history concluded that a Fed that was too inflation-obsessed or insufficiently aware of policy mismatches ended up causing major avoidable economic distress.
The wider political challenge
Although tight monetary policy is necessary to contain inflation, it already has toxic side effects. These will likely increase over time. They demand political answers.
On the one hand, rather than waiting for crises in the Treasury and other markets, policymakers should take action now to ensure that liquidity is guaranteed and that poorly written regulatory policies do not prevent institutions financial institutions to hold public securities. That the banking system weathered covid-19 so well is in part a tribute to the regulatory changes put in place after the Great Recession. The next crisis will probably come from the non-banking financial system. This should be the immediate focus of increased regulatory attention.
Moreover, intense global cooperation was essential at times such as the Latin American debt crisis of the 1980s and the Great Recession. Now is the time to put in place debt restructuring mechanisms, financial supports for emerging markets and increased capacity of the International Monetary Fund and multilateral development banks to respond to the emergency needs of the hardest hit countries. .
Finally, the inflation crisis must not be wasted. A silver lining in the dismal inflationary period of the 1970s was the collaboration of Stephen G. Breyer (then an adviser to the Senate Judiciary Committee), Sen. Edward M. Kennedy (D-Mass.), and the Carter administration on airline deregulation. In this era, high inflation should be a spur to regulatory change – from fighting Jones Act shipping cost increases, to strategic tariffs, to rules that force oil and gas to be transported by truck rather than pipeline, to punitive zoning restrictions – which both reduce prices and improve the functioning of the economy.
Regaining price stability at the lowest cost is far from enough to maximize US economic performance, but it is necessary. Only on the basis of price stability can we meet the profound challenges of accelerating growth, including all Americans in prosperity, and maintaining American leadership at a dangerous global time. . Policy makers must not flinch.
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