The Federal Reserve is in the early stages of tightening monetary policy to fight inflation. Most Fed watchers expect 50-basis-point interest rate hikes in June and July and more after that. Quantitative tightening to shrink the Fed’s balance sheet will also begin soon.
As always, the Fed will be graded on its performance by market reactions, the commentariat, and some members of Congress. In fact, the grades are already pouring in with an overwhelming majority giving the Fed low marks for not tightening sooner. In the jargon, it is “behind the curve.”
I agree that the Fed was late to pull away from the hyperexpansionary monetary policies it started, for excellent reasons, in March 2020. But as interest rates rise, the Fed’s supporters and critics alike should keep in mind three important things.
First, only a minority of today’s excessive inflation can be traced to easy money. The Fed seeks inflation of 2%, as measured by its favorite gauge: the PCE (personal consumption expenditure) deflator. That index recorded a disturbing 6.3% increase from April 2021 to April 2022, which is quite a miss. However, the core PCE inflation rate, which excludes food and energy prices, was 4.9% over the same period.
Those extra 1.4 percentage points of inflation were clearly not attributable to loose monetary policy because the Fed can’t do anything about food and energy prices. They will also mostly disappear when food and energy prices level off. When will that be? We don’t know. For example, no one knows when or how the war in Ukraine will end. But we do know it must happen at some point. Oil prices have soared past $100 a barrel, but they won’t keep rising to $200 or $300 a barrel.
Notice the important subtle point here. For food and energy inflation to decline does not require those prices to fall back to earlier levels, only that they stop rising so fast.
Another nonmonetary source of recent inflation has been the panoply of supply-chain problems which have been both symptoms and causes of the uneven recovery. The amount of extra core inflation attributable to Covid is hard to estimate. One clever attempt, by
of the Federal Reserve Bank of San Francisco, divides all items in the PCE deflator into “Covid-sensitive,” such as used cars and airfares, and “Covid-insensitive,” such as tobacco and hardware.
Over the past 12 months, the Covid-sensitive components have contributed about 3.5 points to core PCE inflation, compared with about 1 point in 2019. To be conservative, let’s use only half of that 2.5 percentage point increase as a rough estimate of the Covid effect. If we do that, our estimate of PCE inflation exclusive of food, energy, and Covid is about 3.7%.
Comparing that 3.7% inflation rate with the 1.5% to 2% rate that prevailed before the pandemic leaves about 2 percentage points of inflation as a reasonable estimate of the cost of running the economy too hot for too long. That’s close to what the Fed, through its monetary policy, needs to take out.
The second important thing to remember is that the Fed’s anti-inflation weapons are less powerful than many think. The central bank pulls the inflation rate down not by magic but by slowing the economy. An old, and perhaps obsolete, rule of thumb held that reducing inflation by 1 percentage point requires about 2 to 2.5 points of additional unemployment for a year. So reducing inflation by, say, 2 percentage points would take four to five years of 1% higher unemployment.
That’s a heavy price. Worse yet, the evidence suggests that inflation is less responsive to unemployment today than it was when those estimates were made, making the Fed’s job even harder. So be careful what you wish for. I don’t think anyone wants the Fed to cause a slump severe enough to knock 4 or 5 points off the inflation rate.
Finally, remember that the effects of tight money on inflation accrue slowly. Prepandemic estimates suggested that anti-inflation monetary policy takes two to three years to have its full effects. So both the Federal Open Market Committee and the commentariat need to be patient. That doesn’t mean the FOMC should delay tightening; it has waited too long already. But it does mean that we should not expect quick results.
Are we doomed to high inflation for years? No. One day, hopefully soon, food and energy prices will level off and the supply chain problems will dissipate. Depending on the details of timing, inflation will fall as quickly and dramatically as it rose. We’ve seen it happen before.
and his colleagues would love to unclog supply chains, alleviate food shortages, and lower oil prices, but they can’t do any of those things. What they can do is raise short-term interest rates. That will help, but don’t expect miracles.
Mr. Blinder, a professor of economics and public affairs at Princeton, served as vice chairman of the Federal Reserve, 1994-96.
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