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There Is a Painless Way to Fix Inflation

At its September meeting, the Federal Reserve again sharply increased its target interest rate by three-quarters of a percent. Asked his thoughts about what effect this tightening will on the overall economy, Chairman Jerome Powell remarked, “I wish there were a painless way…There isn’t.” Actually, there is a painless way: stop raising rates.

The Fed is hardly alone in its inflation fixation. For most voters, inflation tops the list of concerns. The Fed’s moves represent a broad consensus that high inflation imperils the stability of the system, erodes living standards, and must be brought down even at the risk of squashing growth and triggering a recession. Hence why Jerome Powell, the Fed chairman, said in a speech in Jackson Hole at the end of August, “While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses…These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.”
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The lack of doubt now evinced by the Fed, by most economists and many businesses about what the problem is and what to do about it is a troubling sign of economic groupthink. In short, the Fed is making an epic mistake. It should not have done what it’s done, should not be doing what it’s doing, and should not do what it plans to do. Past mistakes can’t be undone, but future ones can be avoided. Groupthink is standing in the way.

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There is, of course, inflation right now, in the U.S. and in most countries throughout the world. There’s also broad agreement about what caused this inflation: too much government spending as the pandemic began subsiding in the spring of 2021; too much pent-up demand from pandemic lockdowns exploding in the summer of 2021 onward created massive supply chain bottlenecks and demand for labor; too much easy money from global central banks kept assets such as stocks and homes elevated; too little action from the Fed until it was too late; and Russia’s invasion of Ukraine led to a doubling or more of the price of oil and gas along with wheat and corn.

Given such a brew, the only remedy now, as longtime inflation hawk Larry Summers said, may be to force a recession with a combination of sharp interest rate increases and even cutting spending and raising taxes to break the fever.

The belief that this period of inflation is so dangerous that it is worth the price of squashing the strongest job and wage market in generation has taken hold in almost every central bank and every government in the developed world.

The sense that inflation destroys wealth and creates the conditions for political instability has deep roots. The determination to fight rising prices stems from the Great Depression and the belief that unchecked inflation in Germany and elsewhere gave rise to fascism and toxic nationalism. The equation that inflation equals political unravelling and war may be sotto voce today but remains embedded in central bank DNA. The experience of 1970s “stagflation” and the inability of policymakers in the United States to tame it led to appointment of Paul Volcker as chairman of the Fed. He sharply increased target interest rates to over 20% and triggered a recession which then paved the way for a spectacular period of economic expansion in the 1980s and 1990s.

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The thesis today is that inflation must be brought down is the culmination of almost a century of central bank orthodoxies. But that leaves one rather crucial question: is it true? Must central banks take aggressive measures to cool the labor market, dampen financial markets, and likely cause a recession? Is it a fact that waiting longer would lead to elevated levels of inflation becoming intractable and entrenched? And should a strong economic recovery after an unprecedented pandemic response globally be crushed because waiting will only delay the eventual pain?

If you listened to what the Fed and many economists are saying, you’d hardly be aware that this has been a two-year period unlike any other. You’d think today is normal and regrettable bout of too much money, too much demand, and high wages. That is not the case. This time it’s different.

In 2020 and in 2021, the U.S. government injected as much as $5 trillion into the system between the two emergency COVID-19 stimulus bills of April 2020 and March 2021 and the expansion of the Federal Reserve balance sheet. That was matched throughout the world by trillions more of stimulus from other countries. That money, for the first time in memory, went directly not just to companies and to banks but also to individuals and small businesses to keep them afloat when the government-mandated shutdowns froze economic activity and mobility. That level of spending surpassed the entire New Deal.

Then, almost simultaneously, the world opened up beginning in the summer of 2021 as vaccines were rolled out, and whatever vestiges of shutdowns remained were largely lifted by this spring. All of the current high inflation begins at that time and was then exacerbated by Russia’s invasion of Ukraine in late February.

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Inflation as a statistic measures year-over-year price increases, which means that until this month, all of the high inflation is relative to depressed economic activity caused by pandemic shutdowns. Inflation started to rise in May of 2021, with a reading of 5%, rose to 7.5% as markets began anticipating the disruptive energy effects of the Ukraine war, then accelerated to 9.1% before moderating over the past months to 8.2%.

Starting now, inflation will be measured off a much higher base. That means inflation is peaking regardless of whatever the Fed did and will do. It is commonly understood that interest rate increase work on a substantial lag, that it takes many months before the effect of those increases show up in changing spending patterns and falling prices. The recent softening of inflation, therefore, cannot be attributed primarily to rising rates. As the effect of pandemic stimulus and the commodity price shock of the Ukraine invasion wear off, and as supply chains slowly work through bottlenecks, inflation is moderating – on its own.

In the fall of 2021, the Fed and chairman Powell appeared willing to see if inflation was “transitory,” and was content to hold off raising rates in the reasonable view that the pandemic created unusual conditions. But what proved transitory was the willingness of the Fed to wait and see; it then reversed course and fell back on the comforting script above, met by accolades by economists and policymakers that it had seen the error of its ways and finger-wagging that it had waited too long to act and had foolishly allowed the proverbial inflation genie out of the bottle.

Now, the Fed is poised to force a recession (though the White House strenuously denies that we are in one now, even after six months of weak GDP). Recession means a halt to the stupendous rise in wages that has seen the bottom quartiles reap meaningful wage gains for the first time in decades and deflate asset prices ranging from stocks (and hence retirement funds) to houses in the belief that doing so is necessary medicine.

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What’s more, given the sheer oddity of what has happened over the past two years, the Fed could have waited much longer before reverting to the old script. It could have and should have seen how that stimulus was digested before precipitously raising rates and doing so in a way that suggest caving to public pressure and panicking about its own reputation. Surely an economy that is seeing the first wages gains in decades, exceptionally low levels of unemployment and high levels of demand doesn’t need to be halted and reversed?

The Fed is led by mandarins whose only brief is the public good. That’s to be lauded, but they are can nonetheless make destructive mistakes. Instead of caving to the pressure of critics playing off an old script, the Fed should have stayed the course it maintained in the fall of 2021 to wait and see how transitory inflation would be in the face of a weird and anomalous two years. It should have then taken the Russia invasion of Ukraine as another one-off distorting the price of oil and commodities. It should have recognized that the fear that high inflation would become embedded and inflation expectations turn into a self-fulfilling inflation spiral was just that: a fear. It should have waited to act rather than burning the village to save it.

It didn’t. Now, with signs of sharp economic slowing, with the housing market not just cooling but nearing freezing, assets prices dropping and the public mood darkening, the Fed can at least stop what it is doing, halt its interest rates increases and slow its attempts to shrink its balance sheet. It doesn’t even have to admit mistakes. It can, as it so often does, just say that new data suggests a different course. And in doing so, it might just stave off a future where unemployment surges, wages stagnate, retirement funds bleed value, and vast numbers of people are made even more economically insecure in order to satisfy economic orthodoxies that are indifferent.

Institutions and policymakers like to take action. Sometimes, the best action is no action. There is still time to halt the onward rush. Pulling back from an outmoded script will at least avoid further damage. Otherwise, we may achieve low inflation at unacceptable cost.

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