The history of inflation, and of how policymakers and pundits responded to it, reveals plenty of motivated reasoning. For decades, people have argued that inflation is not so bad, that it happens because of greed, or that the best solution is price controls. I’d assumed that we had become wiser, but here we are today, with core inflation (excluding volatile food and energy costs) at 6.3 percent, unemployment at 3.7 percent, and the inflation-adjusted federal-funds rate still negative. Yet many observers think that it’s a mistake to raise interest rates any further, and some even believe that monetary policy should be looser.
Raising rates to curb inflation is never popular. Farmers drove their tractors into Washington to protest Paul Volcker’s rate increases. People hate higher rates for good reason: they can chill the labor market, and they certainly drag down the stock market, which is down 23 percent this year. Federal Reserve chairman Jerome Powell has finally admitted that reducing inflation will probably cause economic pain, and the worst could be yet to come. The tight labor market is still contributing to inflation; getting the price level under control will probably mean not only a falling stock market but also lost jobs.
It’s tempting to call off the dogs. One might argue that higher inflation is better than higher unemployment and falling GDP. Another might say that because this bout of inflation is driven by supply-chain problems and expensive oil, monetary policy is an ineffective tool. But today’s inflation is also driven by demand—by too much stimulus and by shutdowns. And even if rising prices were strictly a supply issue, curtailing them would still be the Fed’s job. A contraction in supply that pushes inflation higher requires the Fed to dampen demand before inflation becomes endemic.
Inflation is largely determined by expectations. If people view the Fed as ineffective or unable to curb inflation, then markets, consumers, and workers, expecting higher prices, will ask for higher wages. That causes firms to increase prices, making high inflation self-fulfilling. Uncertainty about the future price level also discourages firms from investing, thereby hindering productivity. Wages may rise, but they won’t keep up with inflation.
Failing to attack the problem may therefore generate an even worse recession than the country currently faces. Such a negligent Fed would lose credibility and need to raise rates even higher to get inflation back down later on. What the Fed is doing now—raising rates by 0.75 percentage points at a time, eventually to reach somewhere around 4 or 5 percent—is a superior alternative. It is administering a mega-dose of antibiotics to kill an infection rather than letting the infection run rampant before cutting off the patient’s leg.
Suppose the Fed didn’t continue raising rates. It would effectively be admitting that it can’t achieve its congressionally mandated mission of low unemployment and stable inflation. In such a world, why would the Fed even bother with monetary policy? A credible and effective Fed is a very powerful tool. But a Fed that won’t raise rates when the economy is overheating is a central bank that can’t cut rates when it is in a recession. And if it gives up on inflation, it also gives up on full employment. Its power depends on its credibility to make hard choices. Some observers have become so accustomed to policymakers doing all they can to boost demand that they’ve forgotten there is no free lunch. The Fed is independent and powerful so that it can make the hard choices nobody wants but everybody needs.
Recessions have happened for many reasons. Sometimes they are unavoidable, owing to big external shocks. Other times they stem from over-investment and the natural business cycle. But the most frustrating recessions come from policy mistakes. A soft landing is still a possibility, if a seemingly remote one. And a Fed-caused recession will not be popular—even if is necessary. The hope is that such a contraction will be less painful than the alternative.
But Powell’s institution does deserve some blame: a series of policy errors, including loose monetary policy well into the pandemic, helped put the economy in its current position. If the looming threat of recession and the current market turbulence feels like the result of a policy mistake, that’s because it is. But the mistake isn’t raising rates now. It was failing to do so earlier.
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