No, the Fed cannot engineer a soft landing, but can wreak havoc trying
Many economists and pundits have been calling on the Federal Reserve to raise interest rates to fight inflation. While the Fed resisted earlier calls to hike rates, arguing that inflation was transitory, a consensus seems to have emerged that the time is nigh. A rate hike in March seems certain, yet raising rates is more likely to raise unemployment and slow growth than have any impact on our current inflation problem.
Those advocating for a rate hike see the current inflation as a problem of too much demand. They argue that the fiscal stimulus was too big, increasing incomes and demand too much. But what we are dealing with is not demand-driven inflation in an overheating economy. The COVID crisis started as a supply-side crisis that severely disrupted production, causing massive layoffs and furloughs. Income and demand crashed. Relief checks partially restored income but the supply side is still shaky—with continuing supply chain disruptions, bottlenecks, and price-gouging. The war in Ukraine will intensify and prolong such problems.
President Biden’s last round of relief is repeatedly targeted as the moment that supposedly pushed the economy beyond full employment. It is undoubtedly true that if the relief had never come, Americans would be much poorer, the unemployment rate would be higher, and inflation would be less of a problem. But this wouldn’t resolve the supply-side problems—and Americans would be worse off.
Pundits suppose that the Fed can engineer a soft landing, i.e. lower inflation without hurting economic growth, by managing inflation expectations. A steady stream of small rate hikes spread over a year or two is supposed to signal to markets that the Fed is serious about fighting inflation. That lowers inflation expectations, so that workers reduce their wage demands and firms temper price increases.
However, there is no evidence to support this belief. For a decade after the global financial crisis, the Fed kept rates near zero to signal that it wanted to raise inflation to its 2 percent target. Both actual inflation and inflation expectations stubbornly refused to budge. In recent months, actual inflation and inflation expectations rose above the Fed’s target even as the Fed continually argued that we were experiencing only transitory inflation. Now the Fed is signaling it is going to hike rates, but longer-term market expectations of inflation remain well-grounded.
Furthermore, the Fed has never managed to guide the economy to a soft landing with rate hikes. Many point to Fed Chairman Paul Volcker’s interest rate hikes in the 1970s — to 20 percent and beyond (and above 15 percent for a couple of years), but conveniently leave out what followed. The economy crashed into a deep recession, and a series of financial crises (the thrift crisis of the early 1980s, the developing nation debt crisis later in the 1980s, and the big bank crisis at the end of the 1980s) can all be traced to Volcker’s experiment. Chairman Alan Greenspan’s tightening in the early 1990s brought on a recession followed by our first jobless recovery, and his tightening in 2004 helped to bring on the global financial crisis in 2008 and another, even longer, jobless recovery.
The only realistic way in which monetary policy can affect inflation is by significantly slowing down the economy and raising unemployment to alleviate wage pressures. Small rate hikes do not reduce inflation. It takes large rate hikes that create financial crises, insolvency, and bankruptcies severe enough to crash the economy—followed by jobless recoveries.
In other words, the Fed would be using unemployment as a tool to control the rate of inflation. The distributional effects of that will likely enhance inequality. The pandemic has been very good for those at the top, but recovery has just started to improve conditions at the bottom. Killing the recovery also means reversing the progress made recently on raising incomes at the bottom.
The evidence shows that in high inflation periods—including the current one—the major contributors are rising rent as well as oil and food prices. None of these is particularly interest-sensitive. People do not usually borrow to buy fuel for their cars, purchase groceries, or pay rent. Indeed, raising rates can even be perverse: higher interest rates reduce home purchases as well as new home construction, meaning that those who might have bought houses have to compete for a limited supply of rentals—pushing up rents and fueling measured inflation.
We need more domestic investment, not less. The pandemic has taught us that the United States must become less reliant on foreign production, and we need massive investments in alternative-energy projects to free us from the grip of OPEC-Plus, which includes Russian oil production.
We must find a better way to think about, and deal with, inflation. There is no one-size-fits-all approach to inflation control, but what is clear is that interest rates are a very imprecise tool for influencing prices. In the current circumstance, the more appropriate solution would be to work to alleviate supply-side constraints. That, however, requires much more work and intentionality than a stroke of a pen to change interest rates, which camouflages as action rather than the cop-out it has proven to be.
Yeva Nersisyan is associate professor of economics at Franklin & Marshall College and L. Randall Wray is professor of economics and senior scholar at the Levy Economics Institute of Bard College.
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