The hope is that the Fed can engineer the proverbial soft landing, whereby inflation returns to around its 2 percent goal and the economy remains strong without a substantial increase in unemployment. Judging by their statements to date, Powell and his colleagues seem to believe they have a good chance of success.
Anything is possible, and wishful thinking can sometimes prove self-fulfilling. But I believe the Fed has not internalized the magnitude of its errors over the past year, is operating with an inappropriate and dangerous framework, and needs to take far stronger action to support price stability than appears likely. The Fed’s current policy trajectory is likely to lead to stagflation, with average unemployment and inflation both averaging over 5 percent over the next few years — and ultimately to a major recession.
Indeed, recent research that I conducted with my Harvard colleague Alex Domash shows that overheating conditions of high inflation and low unemployment are usually followed, in short order, by recession.
A year ago, the Fed thought inflation would be in the 2 percent range for the next year. Six months ago, it was expressing optimism that inflation was transitory. Two weeks ago, it was still buying mortgage-backed securities even as house prices had increased by more than 20 percent. No explanation has been offered for these rather momentous errors. Nor is there any suggestion that the Fed forecasting procedures or the personnel that produced them will change. Indeed, the most important change in the March Monetary Policy Report to Congress was in the wrong direction — the removal of the discussion of the various monetary policy rules that had suggested policy was dangerously loose.
So there is little basis for confidence in the Fed’s assessment of inflation risks. With extraordinarily tight labor markets getting tighter by the best available measures, and wage inflation running at 6 percent and accelerating, high inflation was a major risk even before the events of recent weeks. We now face major new inflation pressures from higher energy prices, sharp run-ups in grain prices due to the Ukraine war, and potentially many more supply-chain interruptions as covid-19 forces lockdowns in China. It would not be surprising if these factors added three percentage points to inflation in 2022. And with price increases outstripping wage increases, a wage-price spiral is a major risk.
In August of 2020, the Fed announced a new policy approach that might never have been prudent, but certainly is not today. It held out the prospect that above-normal inflation can be fine for an extended period of time and ended the traditional Fed approach of responding to expected inflation before it materialized. Essentially, officials switched from the Fed’s traditional “removing the punch bowl before the party gets good” to an approach of “the punch bowl makes people happy. We will remove it only when we see people keeling over drunk.” In today’s high-inflation environment, this new framework should be abandoned.
Powell has emphasized his admiration for Paul Volcker recently. Current inflationary conditions are not as bad as those Volcker inherited as Fed chair in 1979, but they are the worst since then. To prevent inflation from metastasizing, Powell and his colleagues need to be absolutely clear on two propositions that Volcker took as axiomatic.
First, price stability is essential for sustained maximum employment, while overheating the economy leads to stagflation and higher levels of average unemployment through time.
Second, there can be no reliable progress against inflation without substantial increases in real interest rates, which mean temporary increases in unemployment. Real short-term interest rates are currently lower than at any point in decades. They likely will have to reach levels of at least 2 or 3 percent for inflation to be brought under control. With inflation running above 3 percent, this means rates of 5 percent or more — something markets currently regard as almost unimaginable.
Central to success in fighting inflation is establishing credibility that a new paradigm is in place. Recognizing failed strategies, and then abandoning them, is the first step. I hope the Fed will make clear that inflation reduction is its principle objective, and that it will wind down efforts to promote worthy but nonmonetary goals such as social justice and environmental protection. This implies committing to doing whatever is necessary with interest rates to bring down inflation, including movements of more than a quarter-point at some meetings and a rapid reduction of its balance sheet. It also means recognizing that unemployment is likely to rise sometime over the next couple of years.
Paul Volcker would not have had to put the economy through the wringer if his predecessors had not lost their focus on inflation. To avoid stagflation and the associated loss of public confidence in our country now, the Fed has to do more than merely to adjust its policy dials — it will have to head in a dramatically different direction.