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Lowering inflation isn’t a job for a one-trick pony

Jerome H. Powell
Federal Reserve Chair Jerome Powell attends a Central Bank Symposium at the Grand Hotel in Stockholm, Sweden Tuesday, Jan. 10, 2023. Senior central bank officials and prominent academics participated in four panels that address central bank independence from various angles – climate, payments, mandates and global policy coordination. (Claudio Bresciani/TT News Agency via AP)

As the Federal Reserve has embarked on a series of interest rate hikes that threaten to throw the economy into a recession, it is time we rethink how we fight inflation. 

Monetary policy, the actions taken by the central banks, has been the dominant tool for economic stabilization in the United States for the past few decades. This has allowed Congress to largely shirk their own responsibilities for fiscal policy, that so often get mired in politics and squabbles big and small surrounding deficits and debt. 

While central banks have postured as developing policy based on a scientific approach to the economy, they continue to hinge efforts on largely defunct and discredited economic theories. Enter the supposed tradeoff between unemployment and inflation. According to this perspective, once unemployment falls below its “natural” level (which is not even constant), an inflationary process is instigated. Based on this supposed tradeoff, in the past the Fed often raised interest rates preemptively, even when there was no actual inflation because the unemployment rate was “too low”.

As current experience shows, the Fed’s decision-making about interest rates is far from scientific. How high should interest rates go? How quickly should they be raised? The Fed has no solid theoretical backing to inform these extremely important policy decisions. 

Before COVID, even central bankers were openly admitting the lack of theoretical foundations for monetary policymaking. In July 2019, Fed Chair Jerome Powell called the trade-off between unemployment and inflation “weaker and weaker and weaker to the point where it’s a faint heartbeat that you can hear now.” The unemployment rate in the U.S. has been pushed below its “natural” rate time and again without the expected inflation. In 2017, Fed Governor Daniel Tarullo stated the Fed did not “have a theory of inflation dynamics that works sufficiently well to be of use for the business of real-time monetary policymaking.” But despite casting doubt on the economic theories underpinning its policymaking, the Fed has once again reached for the same approach to deal with inflation. 

Behind all the technical jargon of monetary policy is a simple reality that even Fed officials are currently admitting — we are using unemployment as the tool to fight inflation. Susan Collins, president of the Boston Fed, admitted, “I do anticipate that accomplishing price stability will require slower employment growth and a somewhat higher unemployment rate.” In an August 2022 speech, Powell similarly acknowledged that “[t]here will very likely be some softening of labor market,” but promised to “keep at it until we are confident the job is done.” The Fed is forecasting that the unemployment rate will go as high as 4.6 percent (or even 5%), from its current level of 3.5 percent. 

Economists have been equally explicit about how price stability is supposed to be achieved. Larry Summers made news for saying, “[w]e need five years of unemployment above 5 percent to contain inflation—in other words, we need two years of 7.5 percent unemployment or five years of 6 percent unemployment or one year of 10 percent unemployment.” In an interview with Ezra Klein, he admitted “it was so important for the Fed to send strong signals of its determination to contain inflation, even with increases in unemployment.” Summers’ reasoning is accurate within the current policy framework — where inflation is only brought under control by causing higher unemployment — but this is exactly the framework that we need to rethink. 

The Fed considers itself a surgeon, using different tools to successfully operate on a patient. In reality, it has one blunt tool, interest rates, and not much guidance for how to use it. Rather than operating on the patient, it’s hammering it to death with the only tool it has. If the patient comes out of this ordeal healthy, it won’t be because of the Fed, but despite it.

Inflation is moderating for a variety of reasons, most unrelated to interest rates. Still, we have to use the opportunity to rethink our approach, which relies on creating one problem, unemployment, to solve another, inflation. 

Alternative ways to achieve price stability are available. If it’s aggregate spending we are trying to decrease, we can use fiscal policy to do it in a more targeted manner. Fiscal policy can also alleviate inflationary supply-side bottlenecks, something the Fed cannot do, by directing investment to areas where shortages are likely to develop. We have made baby steps in the right direction in the form of the Inflation Reduction Act and the CHIPS and Science Act, which make targeted investments to create additional capacity in renewable energy and semiconductors sectors, respectively. 

What we need is a wholesale rethinking of our framework for achieving price stability to elevate the role (and responsibility) of fiscal authorities, such as Congress, while downgrading the role of the Fed. 

Yeva Nersisya is a professor of economics at Franklin & Marshall College and a research scholar at Bard College’s The Levy Economics Institute

Tags Federal Reserve Inflation Jerome Powell Susan Collins Unemployment

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