How to help the Fed and avoid a recession
Inflation exceeded 7 percent on an annual basis in November. And that was good news — the lowest monthly figure since December 2021. After a sluggish initial response to the uptick in prices, the Federal Reserve has responded aggressively. At its last meeting, the Fed’s Open Market Committee raised short term interest rates to 4.5 percent (the rate was 0 percent at the beginning of the year), with a forecast that rates will continue to rise well into 2023 — even though it recognizes that the rapid hikes risk bringing us a recession, high unemployment and stock market crashes.
While the Fed’s doomsday interest rate response is understandable (its mission is to fight inflation), it begs a key question: Why has the Fed become the “only game in town” for fighting inflation when there are many other options? To avoid an unnecessary recession, we need to pursue policies such as fiscal contraction, supply-side reforms and stiffer antitrust enforcement that fights inflation while fostering a strong economy rather than an anemic one.
Today’s inflation has many causes, including the supply-side disruptions of the pandemic and the war in Ukraine, extraordinary government spending in response to the pandemic and overly accommodating monetary policy. To control inflation, policy needs to keep the economy from overheating and convince people that the inflation genie will go back in its bottle.
Up to a point, the Fed should tighten monetary policy so that the economy stops overheating and inflation stabilizes. But the Fed is trying to do more — essentially cause a recession that brings down inflation and convinces people to expect lower inflation in the future. Economists even have a term – the “sacrifice ratio” – for the excess unemployment necessary to bring down inflation via interest rate hikes. The stock market’s swoon represents collateral damage in this campaign. Making matters worse, interest rate hikes typically work with a lag of a year or more — meaning that in its zeal to make sure it has inflation under control, there is a good chance the Fed tightens more than it needs to but realizes it too late.
Instead of letting the Fed do all the work, policymakers should favor inflation fighting alternatives that leave our economy stronger. At a time of historic federal debt levels and rising interest rates, it is reckless for the federal government to be running budget deficits over 5 percent of GDP. Reducing the deficit cools inflation while enabling us to respond more robustly to the next economic downturn or national crisis. And reduced federal spending cools the economy more directly than lowering interest rates, reducing the risk of over-tightening.
The president and Congress could lower prices in many other ways, from tightening antitrust enforcement to tapping strategic oil reserves and expanding licensing of all energy sources, green and otherwise. Housing price inflation could be ameliorated by permitting the construction of more housing. And lawmakers could allow more immigration to ease labor shortages. Each of the examples above would lower prices while making the economy more dynamic, efficient and stronger. Interest rate increases, in contrast, are a broad suppresser of demand that shrink the economy.
If such win-win possibilities exist, why have lawmakers not widely embraced them? Politics is the easy answer, and it’s not wrong. As unelected bureaucrats, the members of the Federal Open Market Committee have the ability to act without needing to build consensus among politicians, without consequences for their jobs, and without asking for permission. The alternatives all come with political baggage. Democrats oppose expanded oil reserve releases and fear de-regulation. Republicans generally oppose immigration. And no one likes to raise taxes or take away government benefits.
But that is no excuse for failing to try. The costs of gridlock are particularly high right now — it means the Fed takes the lead in inflation reduction, whatever the cost to the economy. And inflation may paradoxically make reform easier. The prospect of inflation reduction with a lower sacrifice ratio may be the lubricant politicians need to overcome gridlock on contentious issues — as the Inflation Reduction Act leveraged our need to do something on inflation to unlock important energy and climate change policies.
Even if politics prevents a comprehensive congressional solution to inflation, there is a lot that the Biden administration can do on its own to bring prices down. The president’s debt relief plan, which will increase deficits, is a powerful example in the wrong direction — exacerbating inflationary pressures without legislative input. The plunge in immigration during the Trump presidency without a formal shift in immigration law demonstrates how much enforcement dictates the flow of immigrants. If the Biden administration committed to facilitating the flow of new immigrants, it would relieve some the wage pressures at the heart of inflation.
While the Fed will remain the cornerstone of our inflation fighting efforts, expecting rising interest rates to do the work alone is daft. Congress and the Biden administration need to work together to make inflation reduction policies a priority. Politics is an unacceptable reason to impose unnecessary pain on our workers and investors.
Yair Listokin is Shibley Family Fund Professor of Law and deputy dean at Yale Law School. He is the author of “Law and Macroeconomics: Legal Remedies to Recessions.” Rory Van Loo is a professor at Boston University School of Law and the author, most recently, of “Inflation, Market Failures, and Algorithms.”