It's a Long, Bumpy Road Back to 2% Inflation
The Federal Reserve has finally started to get real. It increased the policy rate target Wednesday by 50 basis points. More rate hikes are expected as the Fed tries to bring down inflation. But will this be enough? Technically, the Fed is still in accommodative mode; rates are so low they're helping make inflation worse. But if the Fed increases rates too much and too fast it risks a recession. Though it may need to create a recession to bring inflation back down. There are no easy choices.
In the second part of my conversation with Dartmouth economics professor and former Fed economist Andrew Levin, we discuss what the Fed is facing in the next few years, and what it needs to do to bring inflation back down. The conversation has been edited for length and clarity.
Allison Schrager: Do you think the Fed did the right thing by increasing the interest rate by 50 basis points?
Andrew Levin: Unfortunately, the Fed is still not following the basic principles of sound monetary policy that it has laid out on its own website.
What really matters to the economy is the inflation-adjusted interest rate, which is the rate minus inflation. At this stage getting to a neutral rate, where it is no longer pushing inflation even higher, is the top priority. The monetary policy stance is neutral when the federal funds rate is just a bit higher than the underlying trend of inflation.
Right now the underlying level of inflation is running at about 5% once you take out transitory factors, so the inflation-adjusted interest rate is deeply negative (about -4%). Getting to neutral, as Fed Chairman Jerome Powell said himself Wednesday, is still a long way off. He appeared to take the possibility of a 75-basis-point increase off the table, preferring to stick with smaller hikes in coming months. And that means the Fed could still be adding fuel to the inflationary inferno, even by the end of this year.
And as we talked about in our previous chat, it's very plausible that inflation will be headed higher this year, not downwards. So it's clear the Fed has a long way to go. If it's going to start following the principles of sound monetary policy, then that may well call for a federal funds rate in the range of 5% to 8%.
Schrager: Suppose the Fed does increase interest rates to 5% or 6% in the next year or two, would that cause a recession?
Levin: Not necessarily. If inflation is running at around 5% and the Fed raises the funds rate to around 6%, that’s not a restrictive policy, it’s simply the rate that avoids adding any further monetary accommodation and helps keep inflation from rising even higher.
But it's crucial for the Fed to be crystal clear in explaining its strategy to the public, to Congress and to markets. In principle, the Fed could even raise rates one percentage point per meeting as long as they're conveying their plan clearly to the markets, along with their reasoning.
Schrager: Okay, so raising rates to 5% or 6% will simply be moving to a neutral policy stance. But if the Fed wants to bring inflation back down to their 2% target, how would they do that?
Levin: There are two plausible options:
One we’ll call the Volcker option, where the Fed takes action to bring down inflation quickly. But that could be associated with a pretty substantial recession and with severe consequences for workers and families. This happened in the early 1980s, when the Fed under Chairman Paul Volcker raised the federal funds target to almost 20% for a brief period, so what we would call the inflation-adjusted interest rate was extremely high. And inflation did come down very quickly.
But that caused the economy to contract very sharply and we had a very severe recession — the worst recession in the post-World War II era. And then the Federal Reserve was able to ease off the brakes and we actually had a strong recovery in 1983 and 1984 and, in fact, by 1984 people were singing “happy days are here again” because the economy was growing and inflation was much lower again.
The other we can call the Greenspan option, which the Fed followed under Alan Greenspan in the early 1990s. Inflation was around 4% to 5% then and Greenspan wanted it to come down close to 2%. So he pursued a policy he called “opportunistic disinflation,” which meant, "We're not going to slam on the brakes." But if the economy naturally slows or if there are factors like productivity that bring inflation down, then we will allow that to happen.
The opportunistic disinflation was actually successful because of a combination of a number of different events during the first half of the 1990s and into the second half of the decade, including accelerating productivity growth. Inflation did come down to around 2% and then from that point onward the Fed basically just tried to keep it close to 2%.
That approach takes more patience, because you don't know when the opportunity might come for natural disinflation.
Schrager: Would the Greenspan option be sufficient to break the wage-price spiral we spoke of last time?
Levin: I think that the challenge here is that an opportunistic disinflation seemed quite reasonable when inflation was running at 4% and the Fed just wanted to bring it down to 2%. Whereas the Volcker option in the early 1980s seemed imperative at the time because inflation was starting to head into double digits, and there was very broad public support for bringing inflation under control.
Inflation being entrenched at 6% or 8% or 10% over the next couple of years is a very different situation than if inflation settles at 3% or 4%. The options really depend on how it evolves and what consequences are required to bring inflation down.
Schrager: So you’d suggest we spend the next year getting to a neutral stance, with rates at around 5% or 6%. And then we’ll see where we are and see whether or not we can get away with the Greenspan option or if we have to go with the Volcker option.
Levin: Yes. We have to be attentive to risks, and there are many. We are in unchartered territory coming out of the pandemic. There are geopolitical risks at work right now. If those geopolitical risks materialize we could be facing a very different situation in the second half of the year. Or perhaps the U.S. economy will continue humming along. Last week’s report on domestic demand of private consumers and businesses was very strong; it's actually accelerating. Either way, the Fed needs to have a clear strategy and it needs to engage in scenario analysis and contingency planning.
Of course, if the Fed takes too long to move to neutral, then the inflation situation could continue to deteriorate. And that will make it that much harder because inflation gets baked into wages. And then the Volcker option becomes necessary because it's not acceptable to the general public to end up with an inflation rate close to double digits. It’s not good for prosperity and growth and equity. One way or another, we need to bring inflation back down to 2%.
Schrager: If we do get short-term rates to 5% or 6%, what does that mean for the average person? Mortgage rates have already risen above 5%; will they go up more?
Levin: What really matters is interest rates after inflation. If inflation is 10%, you get a 10% raise at work and mortgage rates are 5% or 6%, then that’s not so bad.
Negative inflation-adjusted rates make it appealing for people to borrow and for businesses to ramp up their investment. But if inflation is at 10%, and the Fed raises interest rates to 15% and car loans are up to 15%, then families will have conversations like, “Sorry, we just can't buy a car right now, we have to wait until the economy settles down and interest rates get back to normal levels.”
Schrager: This creates a lot of uncertainty for the consumer. If interest rates are at 2% it's a no brainer that you're getting a fixed-rate mortgage. But if rates are at 5% or 6% and you think they might one day go back down to 2%, except you think they could jump to 15% before they fall, it’s hard to know what to do.
Levin: That’s why knowing what to expect from the Fed is so important, and why the Feed needs to stick with its principles. If rates go up with inflation then there is some stability with real interest rates. Longer-term rates are likely to go up quite a bit over the coming year, though probably not as much as short-term rates. So depending on what kind of time horizon someone has, maybe they should hurry and get the mortgage right now, when rates are still pretty low. Or maybe they should hold off if it's not urgent. But it could be a few years before inflation goes back to 2% if the Fed does what it needs to do.
Schrager: Would 5% or 6% rates also mean stock prices would probably keep going down, too?
Levin: The general approach of financial analysts and economists is that what matters to stock prices is also the inflation-adjusted interest rate. And that rate has been negative for a while. That's a good thing for the stock market, especially for high-tech stocks.
But as we're getting back to our normal times we should expect to see a significant stock market adjustment because real interest rates are going to go back above zero. I think the Fed unfortunately has waited too long to explain to the markets clearly that the party’s over and we need to stabilize inflation.
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