The US Federal Reserve’s resolve to care about jobs as much as it does about inflation is being tested by rising prices.
The debate over the direction of the US economy has entered a new stage as vaccines allow normal life to return, while the lawmakers debating pandemic relief have now turned to schemes for long-term investments in the US economy. The great re-opening has surprised observers in different ways—employment has been slower to return and prices have risen slightly faster than the Fed and many forecasters expected. At the same time, the underlying dynamics of the economy, particularly the connection of price increases to predictable post-recession supply shortages and pandemic-driven social changes, remain in line with the expectations.
For chair Jay Powell, this is the moment to prove that the Fed has learned the lessons of the recovery from the Great Financial Crisis, when employment didn’t return to pre-shock levels for six-and-a-half years. What that means in human terms is that hundreds of thousands of Americans couldn’t support themselves and their families, along with all the trauma and sacrifice that entails. It’s a mistake that current policymakers aren’t eager to make again, and after a multi-year rethink, the independent central bank is prepared to allow inflation to rise in order to meet its employment targets.
Still, a number of center-left economists, notably Obama administration veterans Lawrence Summers and Jason Furman, have argued that the government’s unprecedented spending during the pandemic has teed up the economy to go beyond recovery and toward unsustainable price increases. Such inflation would end, they fear, only when the Fed raised rates high enough to plunge the US back into another recession, akin to the experience when Fed Chair Paul Volcker fought inflation in the early 1980s with a series of rate hikes. “I do not see how any responsible policy maker can fail to recognize that overheating is now the largest risk in the near term US macro outlook,” Summers wrote recently.
As everyone watches how the Fed’s Open Market Committee (FOMC) reacts to the latest data at today’s meeting, what hangs in the balance is more than just future prosperity—equality and political stability may also be at stake.
What is different about the FOMC’s approach today?
In mid-2020, the Federal Reserve announced a change in the way it would attempt to fulfill its dual mandate of balancing inflation and employment. From now on, it would wait to see actual inflation before tightening policy, rather than attempting to get ahead of price increases that are fundamentally difficult to predict. The change came from several years of comprehensive re-thinking, prompted by the institution’s failures after the housing bubble popped in 2008.
“They never got 2% inflation on a sustainable basis and we kept having hundreds of thousands of people join the labor market without inflation taking off,” explains Claudia Sahm, a former Federal Reserve staff economist during the financial crisis who is now a senior fellow at the Jain Family Institute. She argues the new approach of policymakers has been justified. “It was clear that they had made mistakes in their thinking and in their models that led to them not achieving their mandate. Where the Fed landed…was bringing their maximum employment mandate up to be on par with their inflation mandate. That’s the sea change in macro.”
Adam Posen has been inside the kitchen where the sausage is made. The economist and president of the Peterson Institute for International Economics was a member of the Bank of England’s rate-setting committee while the world climbed out of the enormous hole caused by the Great Financial Crisis. “All of that is, I think, excellent changes to policy, reflecting realities that have been demonstrated over the last 20 years,” Posen says of the Fed’s new framework.
Still, waiting to fire until the whites of inflation’s eyes are visible would be nerve-racking during normal economic times. These times aren’t normal. It is “particularly inconvenient to try and implement that when you’ve had a really massive fiscal stimulus and now a positive supply shock of the economy reopening,” Posen says.
What does new US inflation data mean for policymakers?
Governments are taking a different approach to fiscal stimulus than in the years after 2008. After that crisis, it is increasingly clear from hindsight, public support for the economy was withdrawn too soon, underestimating the magnitude of the recession. Inflation predicted to result from stimulus spending and ultra-low interest rates never materialized. Instead, the US saw a “jobless recovery”; in Europe, a debt crisis immiserated millions on the euro periphery while slowing growth across its leading economies.
This time around, two different US presidents enacted large relief bills that pumped $5 trillion into the economy, including significant payments directly to individuals through expanded unemployment insurance and stimulus checks. Meanwhile, the Fed lowered rates and supported financial markets with asset purchases. That world-beating generosity helped millions of people push through a public health crisis.
To explain why they think this effort went beyond what was neccessary, Furman and Summers have focused on the idea of “potential GDP,” a forecast of how much production is possible in an economy. During a recession, output falls below potential, and one reason for government aid is to fill the gap. Per Furman’s calculations, the government’s spending has the US economic cup running over by about $1 trillion.
Now, we’re starting to see prices rise: In June, the average increase of the consumer price index (CPI) year over year was 4.9%, the highest since 2008. This jump can be explained fairly convincingly. For one, last year’s plunge in prices during the onset of the pandemic is exaggerating this year’s growth. For another, much of the overall increase can be isolated in specific products and services affected by pandemic supply shortages, like silicon chips, airline tickets, and car rentals. In Fed speak, these are “transitory” price changes that should pass when supply chains relink and business activity returns to normal. CPI grew less in May than it did in April, for example, and prices of lumber, which has helped drive the inflation narrative, have been falling for weeks.
Still, the Fed’s forecasts suggest it was not expecting quite this burst. Officials predicted that a different measure of price change, based on measures of personal consumption expenditures (PCE), to average 2.2% for the year; in April, it was just over 3%. Unless the pace of price growth slows considerably, the Fed may have to keep raising its forecasts, in turn raising the risk that people start expecting more inflation.
“The idea that they’ve overdone it is pretty strong,” among academic economists, Posen says; even if forecasters generally underestimate output gaps, the new spending still might be in excess of 6% of GDP or more. “The reply to all this is that the Biden administration rightly thinks they are facing existential threats—the pandemic, climate change, to our democracy if [the 2022 election] goes badly. Is it better to have done too much this time than to do have done too little last time?”
For Posen, the political and moral case for “overdoing it” makes sense, but as a matter of optimal policymaking, the current situation leaves something to be desired. “The action moves to, what do you think the Fed should do about it? That’s more contentious, genuinely contentious, the answer isn’t self-evident.”
The real costs of US inflation
If inflation runs a little higher than 2%, what’s the risk? Just a few years ago, after all, IMF economist Olivier Blanchard argued that the Federal Reserve should be targeting inflation of 4% to help goose economic growth and give central bankers more latitude to move rates. Summers has spent recent years writing about how the US desperately needs much larger investment to break out of a period of economic stagnation, adding that central banks “need to raise rather than lower inflation.”
The classic complaint is that high inflation damages savers and benefits borrowers, but teasing out the real effects is difficult because very rarely is any one household entirely either. Posen says efforts to find the real costs of inflation generally succeed once the rate of price growth hits double-digits. “The cost of moving to 3% inflation are essentially none, if that’s all you’re doing,” he says, but negative outcomes can be psychological and political as well.
“We do have very robust evidence from surveys that average working people don’t like inflation,” Posen says. “Even if in the econometrics we can say, we can’t find any evidence that it really hurts you…it convinces people the government is incompetent.”
To Posen, anyone who really believes that the specter of 70s-style inflation is on the horizon should be calling on the Fed to raise rates, but it’s hard to find even critics of the central bank calling for that now. Summers has argued that the Fed needs to talk more about inflation concerns and when it could start tightening by halting asset purchases.
“I tend to view a lot of this stuff as cheap talk,” Posen says of the central bank trying to talk down inflation worries. “I’d rather have the Fed make a more accurate forecast [that] would allow the public to know there is more risk of inflation.”
The main expression of inflation worry is not even at the Fed, particularly since markets seem sanguine and Fed officials continue to project confidence in their new framework. Today’s meeting ended with the bank’s rate-setting committee holding fast to its commitments, but updating its forecasts to reflect faster price growth and a likely interest rate hike in 2023. Instead, inflation is being cited as a reason to delay an infrastructure investment bill that would also address climate change.
“If you were really worried about the economic capacity of the US coming out of this,” Sahm says. “You should be spending every moment of every day pushing for a really good infrastructure package.”
How could US inflation become structural?
Furman, who was not available for an interview with Quartz, recently shared that he views PCE inflation of 4% to 5% in 2021 as the most likely outcome, nearly twice what the Fed has forecast. In a Twitter thread, he drew out the arguments about whether inflation would pass or become a permanent part of the economic landscape. He argues that too many commentators are underweighting the potential for employers to build this year’s inflation into next year’s wage and price increases, for rising home prices to bleed into rent, or for supply problems to linger as demand continues to rise in the medium-term.
Those like Sahm who disagree about this emphasis on inflation argue that it is hard to construct a narrative of permanent, structural change. Retail spending fell this month, she notes, and soon enough direct stimulus to individuals will be spent. Fewer employment contracts are indexed to inflation and unions have far less leverage to win wage increases for workers. Home prices have risen unsustainably for years thanks to laws that restrict building, but inflation has sat comfortably under the Fed’s target.
“The US economy is fundamentally different from the last time that we saw inflation that was out of control,” Sahm says. “We have to engage with the economy that we have now. At the end of the day, inflation was running last year at 1%, this year about 3%, 1 and 3 average 2.”
Among the most influential parts of the Fed’s re-think, she says, was a national listening tour to hear what the public wanted from monetary policy, with a particular emphasis on outreach to minority communities. “What they heard, over and over again, was jobs, jobs, jobs.” That is why you’ve heard more from Fed officials about topics like Black and Hispanic unemployment.
She says when economists rely on models like potential GDP to argue against Fed policies, they are inadvertently betraying a poverty of ambition for the US economy. One assumption the Congressional Budget Office’s forecast uses 2005 as a reference year, a time unemployment was about 5%. But we saw far lower unemployment rates between 2016 and 2020, suggesting potential output is higher than forecast, and during that 2005 reference year, Black unemployment was 10%. “You really want to argue that the best we can do for Black workers in this country is one in 10 unemployed?” Sahm asks.
The opposite fear is that if things get out of hand and the Fed has to push down inflation, the resulting recession would impact the most vulnerable workers. This was in part the logic used by then-Fed chair Janet Yellen in 2015 when the Fed began tightening—gradually hiking interest rates would avoid a sudden change of pace that would disrupt the economy. The result was a plunge in job creation. For that reason, Sahm says, it would be foolish to use the same justification for tighter policy now.
One caveat, Posen says, is that the 2015 tightening was broadly seen by markets as a mistake. A rate increase today might not have the same negative effect on the economy if investors and businesses believe it won’t hurt demand. Still, any rate increases soon are likely to be costly.
“This is a gamble with risks of the Fed not acting now, but it’s worth taking the risk,” Posen says. “It’s really hard to imagine those costs are higher than the costs we’ve had of the Fed undershooting inflation, of the Fed and the [European Central Bank] and [the Bank of Japan] raising rates at times they shouldn’t have raised rates, [and] running the economy below potential.”