economics

How should the Fed respond to the highest inflation in 40 years?

UC Berkeley
Jain Family Institute
Genesis
Response
Penultimate
Finale

Jón Steinsson

UC Berkeley

December 16th, 2021
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.
0 Comments