Why the Federal Reserve Keeps Underestimating Inflation
The Fed messed up. Big time. After almost 40 years of low, predictable price growth, inflation is back: 8.5% at last count and it may go higher still. Some of the inflation is related to pandemic re-opening, but some of it came from serious policy errors. Now the Federal Reserve faces some hard choices. It may even need to cause a recession to bring inflation back to manageable levels. Can it manage that without getting the country into deeper economic trouble?
To better understand all the risks, I asked someone whose own long history with the Fed gives him some particular insights. Dartmouth University Economics Professor Andrew Levin was an early skeptic that inflation was transitory and would go away on its own. Levin worked for a couple of decades at the Federal Reserve Board, including two years as a special adviser on monetary policy strategy and communication. The conversation has been edited for length and clarity.
Allison Schrager: Do you think that the Fed and the financial markets are finally being realistic about inflation prospects?
Andrew Levin: Unfortunately not. The problem is that the Federal Reserve in its projections is still emphasizing a baseline outlook in which inflation comes back down to around 3% within the next few quarters, but Fed officials are not talking about more risky scenarios. In fact, there are a lot of factors that may drive inflation even further upward.
Schrager: And those factors are….?
Levin: First, a year ago the Fed was expecting the supply-chain disruptions associated with the pandemic to be disentangled fairly quickly. But one key obstacle is China, which is still following a zero-Covid policy. We're now seeing more lockdowns affecting major cities like Beijing and Shanghai, and that will probably amplify supply-chain problems over the next six months to a year. In fact, the disruptions could actually be worse than they were in 2020 and 2021.
Another key factor is that the cost of housing is heading up, not down. Ordinary Americans experience this whenever their rental contract comes up for renewal and the monthly rent is raised by a significant margin. The cost of shelter is now rising at an annual rate of about 5.5% and still heading upward. That’s a major component of the Consumer Price Index, and a substantial component of the Personal Consumption Expenditures price index that the Fed looks at.
Schrager: Consumers are feeling pressured by inflation, but a tight labor market means they're getting paid more. Isn't that good?
Levin: Ordinary workers have been experiencing enormous increases in their cost of living over the past year or more. And we’ve also seen extraordinarily high quit rates in the data collected by the Bureau of Labor Statistics. Workers who are changing to new jobs are getting wage increases of 6%, 8%, or 10%, which is not unreasonable given that actual inflation is now running at 8% as measured by the CPI. These are not greedy workers, and this is not what I would call an overheated labor market; this is just ordinary people wanting to be compensated for an increased cost of living. But when a firm raises the wages of its employees, in most cases it then has to pass those higher labor costs through into the prices it charges for its products. And we have seen this before in the 1970s; it’s called a wage-price feedback loop.
The Fed is responsible for ensuring that inflation doesn't get entrenched in the U.S. economy. But my worry is that it's already happened. Inflation isn't entrenched at 3%, it’s now around 6% or 7%, because workers and small businesses are seeing inflation running persistently at levels of 5% to 10%. And the wage-price feedback loop that’s now underway makes it much more difficult to bring inflation back down to the 2% target.
Schrager: Would sorting out the supply-chain issues and stabilizing energy prices be enough to bring inflation down to the Fed's 3% projection?
Levin: Probably not. The problem is many of the models the Fed uses embed the assumption that inflation will naturally revert back to the target of 2%. Those models don’t incorporate the possibility that a wage-price feedback loop can lead to a highly persistent shift in the level of inflation. And many Wall Street economists previously worked at the Fed and continue to use those methods and rely on those assumptions; in effect, there’s a real risk of groupthink.
This is why I’m such a strong believer in having a more diverse group of people doing analysis and making decisions. A variety of life experiences is critical to making the right calls, especially in a context where people are encouraged to question assumptions and not assume that everything is going to continue the way it has been in recent memory.
And now we have to add to the list that the Russian invasion of Ukraine has caused immense changes in the global supply of fertilizers and grains as well as energy. Of course, the Federal Reserve tends to exclude food and energy in assessing underlying inflation. But that’s very frustrating for ordinary consumers because that comprises such a large share of the family budget. If this were just a temporary commodity price shock, it would make sense for the Fed to ignore it in assessing the underlying trend. But given the global factors that we’re facing now, food and energy prices are projected to rise even further over the coming year, and may well remain elevated for the foreseeable future.
Schrager: We can't change the past, so what needs to happen now?
Levin: If in fact these upside risks materialize and inflation over the next three to six months heads close to double digits, then the markets will realize that the Fed still has a very long way to go.
We know from experience in the 1970s that the public will not be satisfied with allowing inflation to continue running at 5% or 10%, so the Fed will have to formulate a more assertive plan for bringing it back down to their 2% target. That might take multiple years, and would hopefully avoid the need for a recession to reverse inflation.
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