Curbing inflation comes first, but we can’t stop there

October 31st, 2022

The United States right now faces as complex a set of macroeconomic challenges as at any time in 75 years.

That is not the same as saying it faces its darkest economic moment. Our current situation includes strengths such as low unemployment and is by no measure as grave as the 2009 financial crisis or 1970s inflation. What stands out, however, is the number of serious, interconnected problems demanding attention.

Consider the links in this chain of macroeconomic challenges:

First, an economy that even progressives such as Paul Krugman recognize as overheated is operating with a core inflation rate that is close to 7 percent and is not yet declining — with the latest monthly figure exceeding the latest quarterly figure, which in turn exceeds the latest annual figure.

Second, the combination of the adverse effects of inflation and the adverse effects of necessary anti-inflation policies has prompted a consensus prediction of recession beginning in 2023. The most recent Federal Reserve projection suggesting that inflation can be brought down to 2 percent without unemployment rising above 4.4 percent is simply not plausible as a forecast.

Third, the Fed has raised interest rates in a way that markets would have thought unlikely in the extreme only a year ago. Markets are reeling from the shock, with the possibility that normal trading could break down in the Treasury bond market, an event that if unchecked would have significant ramifications for other markets.

Fourth, the global economy is everywhere challenged by rising U.S. interest rates and a dollar exchange rate at record levels against some key currencies. The fallout from the war in Ukraine has also been devastating to many economies. A weak and closing global economy hurts our exporters and markets and dangerously implicates vital national security interests.

And all this while we are still finding our way on covid-19, cases of which are likely to rise this winter. An estimated million-plus workers have been pulled out of work by long covid. Moreover, covid effects appear to be slowing U.S. productivity growth, with productivity actually regressing so far this year.

Each of these issues could be all-consuming in normal times. How should policymakers respond to the combination of them all?

Inflation first and foremost

The objective of policy should be clear, at least. What is most important is that the maximum number of Americans who want to work are able to work at as high an income as possible, now and in the future. Other matters — from the level of government debt to the functioning of financial markets to business incentives to inflation — are not important for their own sakes but because of their effects over time on employment and income.

Put another way: Questions of macroeconomic policy are not about values but judgments about the ultimate effects of various actions. As Fed chair during the early 1980s, Paul Volcker famously tamed out-of-control inflation at the cost of a severe recession. But he did so not because he cared less about unemployment or worker incomes than his predecessors did but because he rightly recognized that delay in containing inflation would only mean more pain down the road.

This principle can be seen in the current labor market. Even as job openings have risen to unprecedented levels and labor shortages have empowered workers, Americans’ real incomes have declined significantly. Unless inflation comes down, workers will not see meaningful increases in their purchasing power — and many of them will continue to doubt the government’s ability to carry out basic tasks.

That’s why it’s vital that the Federal Reserve not waver. Chair Jerome H. Powell has vowed to impose sufficiently restrictive monetary policy to return inflation to within range of the Fed’s 2 percent target. The more confident that workers, businesses and markets are that the Fed will follow through on that, the less painful the process will be.

From this perspective, the Biden administration (unlike some in Congress) has been right to avoid putting public pressure on the Fed. Such pressure should be seen as counterproductive even by those most alarmed about the dangers posed by aggressive Fed action. Pressure is unlikely to lead to lower short-term interest rates — the Fed is more likely to stiffen its spine to avoid looking as though it gave in to political pressure — while markets would react to it with higher risk premiums and rising inflation expectations. Pressuring the Fed can only hurt the economy.

The idea that the economy has overheated, and thus monetary policy needs to be restrictive, is at last widely accepted even by acolytes of “team transitory.” But those who early on argued that inflation would be short-lived now proceed from two valid points — that monetary policy operates with lags and that recession risks are rising — to the problematic conclusion that the Fed has done enough to contain inflation and risks causing an excessive downturn with more tightening.

Of course, the Fed will have to judge carefully when it can be confident that the economy is on a path back to durable price stability. Private-sector housing and some other data suggesting that inflation is likely to subside in 2023 are encouraging but do not yet provide a basis for that confidence.

It is an elementary fallacy, however, to say that since inflation expectations appear contained, the Fed can relax. Expectations are contained only because the Fed’s tightening has been far more aggressive than was expected. And today’s expectations are conditioned on an assumption that interest rates will rise by close to two percentage points from current levels.

Those who believe the Fed is close to having done enough need to explain their view. If they believe that interest rates above 4 percent, in an economy with 7 percent core inflation, will cause a recession serious enough to reduce inflation below the Fed’s 2 percent target, they need to explain why. I find it absurd. Perhaps the argument is that preventing an overly deep recession is so important that it’s worth abandoning the Fed’s inflation target. But proponents of this view need to explain how, if inflation remains well above 2 percent, we can avoid continued erosion in 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 shrank from the immediate consequences of restrictive policy. History remembers them poorly. Conversely, I am not aware of any instance in which history has concluded that a Fed that was overly fixated on inflation or insufficiently aware of policy lags ended up causing major avoidable economic distress.

The broader policy challenge

While restrictive monetary policy is necessary to contain inflation, it is already having some toxic side effects. These will likely increase over time. They demand policy responses.

For one, rather than waiting for crises in Treasury and other markets, policymakers should take steps now to ensure that liquidity is backstopped and that poorly drafted regulatory policies do not inhibit financial institutions from holding government securities. The fact that the banking system came through covid-19 so well is in part a tribute to the regulatory changes put in place after the Great Recession. The next crisis will likely come from the nonbank financial system. That should be the immediate object of increased regulatory attention.

Additionally, intense global cooperation has been essential at moments such as the Latin American debt crisis of the 1980s and the Great Recession. Now is the time to put in place mechanisms for debt restructuring, financial backstops for emerging markets, and increased capacity for the International Monetary Fund and the multilateral development banks to meet the emergency needs of the hardest-hit countries.

Finally, the crisis of inflation should not be wasted. A bright spot in the dismal inflation period of the 1970s was the collaboration of Stephen G. Breyer (then counsel 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 changes — from addressing Jones Act increases in shipping costs, to strategic tariffs, to rules that force oil and gas to be transported via truck rather than pipeline, to punitive zoning restrictions — that will both reduce prices and make the economy work better.

Regaining price stability at as low a cost as possible is far from sufficient to maximize American economic performance, but it is necessary. Only from a foundation of price stability can we meet the profound challenges of speeding up growth, including all Americans in prosperity and maintaining American leadership at a dangerous global moment. Policymakers must not flinch.