Central Bankers Are Handcuffed by Old Narratives

The old story led to mistakes. The new one might well do the same.

In March, inflation surged to 8.5%, the highest since 1981. The cause was and remains an excess of demand over supply. The question is how much of this imbalance is due to higher demand, driven partly by fiscal and monetary policy, and how much is due to interrupted supply, caused first by the pandemic shutdowns and then, since February, by sanctions on Russia. Without knowing the answer, we can’t easily say how policy should respond.

The old story emphasized an edict from standard macroeconomics: If temporary supply interruptions are the main thing, you shouldn’t brake the economy by restricting demand, which will cut output further and raise unemployment. It’s better to put up with the transitory rise in prices induced by a supply shock and wait for the blockages to clear.

Long before Russia attacked Ukraine and the U.S. and its allies responded by choking its energy exports, inflation had moved higher than most analysts had expected. Prices were rising in sectors not directly impacted by the shutdowns. Attention was turning to signs of tightness in the labor market, and wages were edging higher as well. But none of this plainly refuted the old story: It’s a supply-side issue, so the inflation will be transitory. Russia’s war added a new supply shock of unknown scope and duration – but if the old story was right in January, it was still right after Putin launched his invasion.

On March 16, the Federal Reserve raised the policy rate by 25 basis points and projected more increases to come – enough, according to its closely followed “dot plot,” to leave the policy rate at a little under 2% by the end of the year and a little over the supposedly neutral rate of 2.5% in 2023. This very gentle liftoff seemed to accept the old story: It promised to leave substantial stimulus in place all through this year. But then the Fed’s officials turned more hawkish, guiding investors to expect increases of 50 basis points next time and at subsequent meetings – implying a substantially higher policy rate by December. This week the Fed duly delivered the first of these bigger increases.

So analysts are asking new questions. Just how high will rates need to go? If inflation persists above 2%, won’t the “neutral” rate of interest be higher than 2.5%? How much higher? Can inflation be controlled without a recession?

The Fed was reluctant to raise rates because the prevailing view dismissed fear of inflation as an anachronism. To begin with, this was quite plausible. For more than a decade after the Great Recession, the abiding challenge for monetary policy had been inflation that was persistently too low. With the short-term interest rate at zero, conventional monetary policy couldn’t stimulate demand any further. Unconventional measures – large-scale central bank purchases of debt (so-called quantitative easing) – helped lower long-term interest rates, but only by raising asset prices to worryingly high levels, and still not enough to get inflation back on target.

Timely fiscal stimulus would have helped. So might bolder use of unconventional measures – such as direct monetary financing of government spending (“helicopter money”). Instead, the Fed adjusted its monetary policy framework to address the matter more subtly. It said it would keep interest rates at zero for longer than would previously have been deemed wise, up to and beyond the point at which inflation was back at 2%, even seeking a temporary overshoot rather than treating the target as a ceiling. This promise to keep interest rates “lower for longer” and embrace a spell of above-target inflation would shift expectations and provide, in effect, additional stimulus.

Complementing this tacit relaxation of the inflation target, the Fed tweaked the other part of its so-called dual mandate, emphasizing “maximum employment” as opposed to “full employment.” By full employment, economists usually mean the highest rate of employment consistent with stable inflation. Restating the mandate in terms of maximum employment signaled that the Fed was more skeptical than before about pressure from the labor market on prices. Running the economy hot, it was thought, would draw discouraged workers back into the labor force, making “full employment” hard to gauge and an unreliable guide. And, again, why worry? A period of higher-than-target inflation was desirable.

Lower for longer was in. Fear of inflation was out. Add in a few more components, and your response to accelerating inflation is, “It’s transitory.”

First, the pandemic caused demand to lurch away from services such as travel and hospitality toward goods – a temporary deviation that worsens short-term inflation. As demand shifts back, this short-lived pressure will reverse.

Second, don’t be misled by parallels with the 1970s and 1980s, when energy-price shocks led to persistently high inflation and a subsequent Fed-induced recession. Back then, wage-price spirals were a thing. Workers saw inflation and demanded higher wages, which forced up prices – and so on, in a stubborn inflationary cycle. This doesn’t happen nowadays, partly because the bargaining power of labor is so much lower.

Also, if price and wage inflation stays high, it’ll be easier for the Fed to nip the problem in the bud. In 1980 inflation stood at nearly 15% – after years of upward drift and erratic, ineffective efforts to assert control. That history of inattention made it harder to get a grip once the Fed resolved to. As a result, Paul Volcker had to shock the economy, raising the policy rate at one point to 20%, causing a recession. In contrast, today’s Fed has a decades-long track record of low inflation, so it doesn’t have to crash the economy to prove it’s serious. A mild and gradual rise in interest rates – from “accommodative” to “neutral” – will suffice.

That’s why expectations of long-term inflation are securely anchored. Rapid growth, low unemployment, unprecedented numbers of unfilled job openings and enormous, if diminishing, monetary stimulus (an inflation-adjusted short-term interest rate of minus 6%) haven’t led investors or consumers to expect high inflation beyond this year or next. Inflation expectations tend to be self-fulfilling – so there’s no cause for concern.

Finally, again for the sake of argument, say inflation lingers well above target. How bad would that be, really? Come to think of it, there’s a good case for raising the inflation target anyway – to 3%, say, or why not 4%? A higher target would mean that the policy rate would be higher throughout the course of the business cycle, and less likely to hit the dreaded zero lower bound when demand slows. So the costs of assuming that the spike in inflation is transitory and then being proven wrong are low at worst. Making this mistake could even be a blessing in disguise.

That was the old story.

Welcome to the new story.

The preoccupation with “maximum employment” and running the economy hot has produced record-breaking measures of tightness in the labor market. Though the number of people employed hasn’t yet returned to its pre-pandemic level, suggesting that the economy is still some way from “maximum employment,” the figures for quits and job openings are setting records. Many of the people who stopped work because of Covid and the shutdowns might never rejoin the labor force, so who knows what “maximum employment” even means?

Meanwhile, employers are looking for workers and bidding wages higher. The view that pay wouldn’t respond to rising prices assumed that workers lack bargaining power and/or fail to notice slippage in their living standards. It turns out that in tight labor markets, workers are emboldened to quit and look for better terms, so they do have bargaining power. And with inflation approaching 10%, increases in the cost of living don’t slide by unseen.

Though the switch of demand from goods back to services is indeed under way, it isn’t helping as much as was hoped, partly because services such as health care and housing are also getting more expensive. The spreading pressure of higher prices is noted – and obsessed over – by social media. Inflation is trending.

So much for well-anchored expectations. The 10-year break-even inflation rate (the market’s estimate of average inflation over the next 10 years) has risen to roughly 3%. Consumers’ expectations of inflation are rising faster. The University of Michigan’s widely followed survey shows consumers expect 5.4% inflation over the coming year, compared with 4.9% a month ago and 3.1% a year ago. Richard Curtin, who’s directed the survey since 1976, says “There is a high probability that a self-perpetuating wage-price spiral will develop in the next few years… Much more aggressive moves against inflation may arouse some controversy. Nonetheless, they are needed.”

Remember how curbing inflation, should it be necessary, would be easy? The concern that faster tightening might cause a recession is now at the front of investors’ minds. It makes the Fed’s challenge all the more tricky because, if the choice really is between persistently higher inflation and recession, the argument that moderately higher inflation might not be such a bad thing is likely to command growing support. Granted, this idea is much more popular with economists than with voters, who tell pollsters that the rising cost of living is among their most pressing concerns. Indeed, the new narrative is replete with reports of the burden that higher inflation imposes on ordinary, and especially low-income, households. In the end, support for a higher inflation target is unlikely to prevail. Even so, expert discussion of the pros and cons could become yet one more factor sustaining inflation expectations and working against the Fed’s efforts to restore control.

So the old story was wrong and the new story is right?

Unfortunately, it isn’t so simple. Crucial elements of both narratives were, and still are, correct; others were, and still are, uncertain. The Fed was right, for instance, that a promise to maintain stimulus as inflation rises to, and even somewhat above, the target makes sense when interest rates have fallen to zero. But the view that inflation was no longer a risk to be taken seriously was wrong. And despite the need to keep interest rates lower for longer, the Fed did delay its move toward tightening – as it now admits – longer than it should have.

The old narrative is almost certainly right that the surge in inflation has a big transitory component – but the inference that all of the surge would naturally reverse without corrective policy action looks wrong. Consistent with this, a faster pace of tightening than the one the Fed was advertising until days ago will be needed – but it would be reckless to suppose that, because of its errors to this point, the Fed should stun financial markets with much higher interest rates regardless of the risk of recession.

In short, the danger resides in swallowing either of the narratives whole. Yet, in a phenomenon that surely has as much to do with social psychology as with technical expertise (or lack of it), analysts and pundits alike are apt to do exactly that.

Paradoxically, the seeming coherence of the respective narratives is what makes them such poor guides for policy. The problem isn’t that they’re simplistic: Often great ingenuity is required to make every piece of information fit the preferred story. But once that effort has been invested, the narrative can withstand a lot of countervailing evidence. And a story is especially durable if it aligns with strong political or ideological prejudices, as economic narratives often do. (Progressives want monetary policy to prioritize high employment; conservatives put more weight on stable prices.) Good policy needs minds that stay open to fresh and sometimes disobliging information, and narratives make that harder.

Where does this leave the Fed? With quite a challenge, to put it mildly. Olivier Blanchard, formerly chief economist at the International Monetary Fund, acknowledges the differences between the inflation of 1975-83 and what’s happening now, but also notes one disturbing similarity: Not since then has the gap between inflation and the stance of monetary policy, as measured by the real policy rate, been as big as now. The Fed has a lot of catching up to do.

In future, the Fed should see its task as simpler and more modest than it has of late – to keep demand on a broadly steady track, consistent with 2% inflation and trend growth in output. To do this, it would have to be more nimble, and sometimes more forceful, in responding to shifts in demand. And its officials would have to forswear narratives that purport to explain every economic fluctuation, that claim to justify departing from the normal track in pursuit of “maximum employment” or other ghostly objectives, and that commit the central bank to a given stance of monetary policy regardless of how demand is evolving.

As supply conditions change, this approach would mean inflation that was sometimes lower than target and sometimes higher – but the overshoots and undershoots would be contained. Changes in interest rates might be more frequent but they’d be easier to anticipate, less abrupt and less apt to destabilize the economy. Central bankers should be suspicious of narratives that encompass too much and tie them down. A simpler mandate and an open mind would serve them better.

Bloomberg News provided this article. For more articles like this please visit bloomberg.com.

Read more articles by Clive Crook