How Should the Fed Respond to the Highest Inflation in 40 Years?
Jón Steinsson and I debated this question at Pairagraph. We disagree on how much the Fed should raise interest rates and how to best to achieve the dual mandate. It's a thoughtful conversation.
Inflation is up a lot this year, and all eyes are on the Fed to see what they will do about it next year. Pairagraph—an online forum for written dialogue between pairs of individuals—invited Jón Steinnson to debate what the Fed should do.
I know, I know. More economists blathering on about the Fed. I promise it’s a good conversation. Plus, our pairing contrasts academic and policy-world macroeconomics well. Jón Steinsson is currently a professor at Berkely and co-director of the NBER’s Monetary Economics group. He finished his Ph.D. at Harvard in 2007, the same year I finished mine at Michigan. We have broadly similar training in macro, and both work on the effects of monetary and fiscal policy. Even so, our professional paths post-Ph.D. are quite different. And that’s a recipe for a great debate.
Below is the four-part series at the from Jón Steinsson and me. It was too hard to excerpt, so I reproduced it in its entirety. Please visit the Pairagraph. They have several debates, including from economists like Jason Furman versus Daniel Mitchell and Erik Brynjolfsson versus Bob Gordon and Harold Uhlig versus JW Mason. Also please consider donating to the site. I did. Thanks to Jonathan Stern and Carter Duncan for creating this space for dialogue.
Here’s Jón Steinsson and I on the Fed.
Part One - Jón Steinsson
Jón argues with high inflation now and expected next year; the Fed should raise its interest rate to 2.5%.
Inflation over the past 12 months has been 6.9% as measured by the CPI. This is the highest headline inflation reading since the early 1980s. Stripping out food and energy yields a core CPI inflation rate of 5.0%, which is the highest reading of that measure since 1991. Over the same time period, unemployment has fallen from 6.7% to 4.2%. Although higher than its value pre-Covid (3.5%), this is among the lowest levels of unemployment the U.S. economy has ever experienced.
So, what should the Fed do about this?
Much depends, of course, on how one expects inflation will evolve over the next 12 months. Professional forecasters currently expect a sharp fall in inflation over the course of 2022 to 2.7% for headline CPI inflation (2.6% for core CPI inflation). I worry that this forecast is overly optimistic. Demand is likely to remain high next year due to high liquid savings of households and sky-high asset prices. Supply disruptions will likely abate some, but it is hard to forecast how fast labor force participation will recover from the Covid shock. Furthermore, some knock-on effects of this year’s inflation in the form of high wage inflation in 2022 is likely to put pressure on costs. For these reasons, I think the most likely outcome for inflation in 2022 is something between 3% and 4%. If all goes well, inflation might be in the 2% to 3% range by late 2023.
What the Fed should do also depends on one’s view about slack in the labor market. As noted above, unemployment is already very low. Abstracting from special Covid factors, unemployment can likely fall somewhat further without causing overheating. But it seems prudent to venture into that territory with some care. Labor force participation, however, is still far below its pre-Covid level. Some of that fall may be permanent (e.g., due to retirement). The rest may take time to resolve itself, and in the meantime is holding back the productive capacity of the economy – something the Fed must recognize as it tries to find a balance between supply and demand in the economy. These considerations suggest to me that the Fed should (at least) be aiming to bring the federal funds rate up to a roughly “neutral” level reasonably quickly.
That raises the question: What is the neutral level of the federal funds rate? Here it is essential to think in real terms, i.e., to consider what real interest rate a given federal funds rate implies. In other words, we need to consider what the neutral real rate (r*) is. Back in the 1990s the consensus view was that r* was something on the order of 2%. Most economists believe it has fallen since then. I am very uncertain about what r* is at the moment. But I think it seems reasonable to suppose it might be close to zero.
Putting this all together, I think the Fed should be aiming to raise the federal funds rate relatively quickly up to about 2.5%. My preference would be to start rate increases at the March 2022 meeting and raise rates by 25bp at each meeting until the federal funds rate reaches 2.5%. As always, the Fed should closely monitor developments during this period. If inflation falls faster than I expect or the unemployment rate starts rising, the Fed should reassess. On the other hand, if inflation in 2022 and 2023 is higher than I expect, the Fed should raise the federal funds rate faster and to higher levels.
The market currently forecasts only a few quarter-point rate increases in 2022. This forecast implies substantially negative short-term real interest rates over the course of 2022. To me, that is too accommodative policy given the current state of inflation and unemployment.
Part Two - Claudia Sahm
Claudia argues for less, countering that reality, not expectations are key in the Fed’s new policy framework.
I firmly disagree with Jon Steinsson. What the Fed does next year should not depend on “how one expects inflation will evolve over the next twelve months.” It must depend on workers, all of them.
The Federal Reserve has a dual mandate from Congress of maximum employment and stable prices. Moreover, the Fed should adhere to the principles in its new strategic framework, which set “broad-based” and “inclusive” employment, as well as an average of 2% inflation as two goals consistent with its mandate.
Another critical shift in the framework is its heightened emphasis on real-world outcomes, not forecasts and theory. I worked at the Fed from 2007 to 2019. I know why the new framework was needed. The slow, inequitable recovery after the Great Recession was a policy failure for the Fed. It stepped away too soon in 2015, leaning on the specter of inflation and a lack of faith in workers coming back. As a result, millions of families never regained their financial footing, and overall economic growth was slower than in the past.
Then Covid struck. Within two years, it has smashed through a series of tragic records in the United States: worst pandemic in over a hundred years, highest unemployment rate since the Great Depression, near shut down of a $20 trillion economy to protect us, twice as many American lives lost than U.S. casualties in World War II, and yes, overall inflation now higher than at any time since the 1980s.
The Federal Reserve has been a bedrock of good policy during this crisis. It was the lender of last resort in the spring of 2020. It has used all its tools—federal funds rate, lending facilities, asset purchases, and communication—to get us out of the recession and push an even recovery as fast as possible. It’s working, and it’s not over.
Time did not start in the spring of 2021 when inflation picked up; the pandemic did not end when vaccines rolled out. When I listen to debates outside the Fed, I am stunned by how little context remains. Covid is the enemy. Inflation is only one of its offspring.
So, what should guide monetary policy now? Jobs. The Fed agrees. Yesterday, Chair Powell said, “the Committee expects it will be appropriate to maintain this target range [a federal funds rate at zero] until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment.” I agree.
Maximum employment is about the margin: are the workers in the proverbial “last in” group back in? Yes, “maximum” reminds us of some limits; zero unemployment is not possible. There are always workers moving between jobs—what’s referred to as frictional unemployment—and structural problems exist like discrimination that the Fed cannot end on its own.
Even so, unemployment of nearly 7% among Black workers, as one example, is not the best we can do. We know that from February 2020, and people on the margins have always known it. Fifty cents more for gallon milk is a burden for many families; no paycheck is a crisis.
My policy forecast for 2022 also differs from Jon’s. I expect three 25 basis-point increases in the federal funds rate starting in June. My forecast assumes the pandemic is contained, monthly inflation steps down next year, and the strong labor market recovery continues.
That said, it’s only a forecast, not a pre-set course. I adhere to the ‘Fed Doctrine of Humility.’ In 2010, then Division Director, Dave Stockton, put it well, “our forecast had a half-life shorter than a jar of mayonnaise in the Mojave Desert.” Amen.
The Fed knows what it doesn’t know. It knows that it’s workers, producers, and small businesses who will tell us mission accomplished.
Part Three - Jón Steinsson
Jón counters that actual, high inflation is inconsistent with stable prices and risks a recession from rapid tightening.
I am sympathetic to the notion that running the economy hot is likely to have large benefits, especially for disadvantaged groups. It follows that cutting recoveries short prematurely has large costs. In several past recoveries, the Fed has tightened policy preemptively (1994, 2004, 2015) even without any serious sign of inflation on the horizon. These actions were based on a worry that unemployment was falling below the NAIRU. Subsequent experience suggests that the NAIRU is much lower. This has rightly led the Fed to be more cautious about preemptive tightening, something that is now enshrined in their policy framework.
But it is one thing to be patient when inflation is hovering around 2%, and it is quite another thing to maintain substantially negative real interest rates when inflation rises to 5%. We are no longer talking about preemptive tightening. Inflation has arrived.
This has two consequences. First, the other part of the dual mandate (stable prices) now calls for tighter policy. I don’t see how this can be ignored. Second, nominal interest rates must rise simply to maintain the same level of policy accommodation.
Now, I think it is quite possible that inflation will subside next year along the lines the Fed and professional forecasters currently forecast. But humility is in order when it comes to these forecasts. They have been very wrong lately.
One of the most important achievements of monetary policy since Paul Volcker is the anchoring of inflation expectations. This anchoring cannot be taken for granted. It is predicated on a belief that the Fed will take strong action to bring down inflation if inflation rises substantially above target. The experience of the 1960s and 70s shows us what happens when the private sector stops thinking the Fed will strongly counteract inflation. This is a lesson we don’t want to relearn.
My proposal to raise the federal funds rate by 225bp over the course of 2022 and early 2023 may seem hawkish to some. But remember that this policy is meant only to bring the real interest rate to a relatively neutral rate of zero. Hopefully, inflation will subside and nothing more is needed.
What everyone wants at the moment is a soft landing for inflation so that we can focus again fully on maximum employment. The question is how best to attain this. My view is that bringing real rates up to zero relatively quickly reduces the probability of having to do something much more painful later. I worry that the Fed’s view (and Claudia’s) is too far in the “let’s hope for the best” direction.
Part Four - Claudia Sahm
Claudia warns standard tools of macroeconomics won’t guide the Fed to maximum employment and stable prices.
It’s not, as Jon Steinsson said, that the Fed “running the economy hot is likely to have large benefits, especially for disadvantaged groups.” It’s the law. While gray area exists in how much Fed officials can profit from their private discussions of monetary policy, the Federal Reserve Act of 1977 is clear: maximum employment is a mandate from Congress along with stable prices.
Since the Fed received its mandate, economists at the Fed and in elite academic departments have argued erroneously that the best we can do on employment is to keep inflation low. The recovery from the Great Recession drove a stake through that zombie idea of the “natural rate of unemployment,” the guess of the level below which inflation takes off. It’s impossible to estimate with any certainty and is a sleight of hand that’s cost millions of American workers dearly. Finally, it is counter to the spirit of the dual mandate. Tradeoffs may exist but inflation is not pre-eminent in the law.
Jon admits the Fed has consistently under-estimated how low unemployment can sustainably go, but then he turns around and argues that today’s inflation is a clear exception. No, half a year of higher-than-normal inflation is not a reason to abandon the millions still on the sidelines due to Covid.
Our inflation this year is not due to monetary policy creating too much demand. It’s about a deadly pandemic and an insufficient public health response. Monthly inflation had been stepping down from its high in late spring until the delta swept the globe. It further snarled supply chains and made people afraid of going back to face-to-face service spending.
It is winter now, and the pandemic is worsening. We are under attack from highly infectious Omicron. It’s unclear whether this new wave will push up inflation by restraining supply more or if it, along with expiring fiscal relief, will reduce inflation by lowering demand.
Regardless, the Federal Reserve is a sideshow, albeit one with which many economists and market observers are obsessed. The standard tools of the academic macro are worse than useless to guide policy. In addition to the natural rate of unemployment, there’s potential output, which assumes a 10% Black unemployment rate, inflation expectations which are a murky concept at best, and the natural rate of interest, which has fallen for decades, largely due to structural changes in the economy.
The Fed did a long-overdue reboot on its strategy to attain the dual mandate. It’s time that academic macroeconomics pitched in. There are exciting developments in the field, some of which Jon Steinsson has contributed. I eagerly await more.
Want to get inflation down? I do and Jon does too. Then get Covid under control. Covid does not care whether the federal funds rate goes up three quarters or two percentage points. We must contain it or people will suffer financially, whether it’s higher prices, no paycheck, or cuts in benefits. If not, people will also die and that’s an infinite and unnecessary price to pay due to Covid.
In Closing
I very much enjoyed the debate with Jón Steinsson. I hope you enjoyed it too.
While we disagree on monetary policy next year, I appreciate his grounding in the models and the facts. It’s not about either of us being right or wrong. We firmly agree economic policy that benefits people is the goal. Diverse views are crucial now.
Next year will be a wild ride, again. I am rooting for the Fed and look forward to many more thoughtful debates about the economy and the best path forward for policy.
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The material in Part 4 appears to be duplicated.