"THE Fed is a bit behind the curve", worries an official at HSBC. The Fed is always behind the curve on inflation, says Charles Plosser, president of the Philadelphia Fed:
If borrowing begins to surge and those reserves start to pour out of the banking system, Plosser worries, “that’s going to put pressure on inflation.” The result: the Fed could be forced to raise interest rates faster and earlier than it would like and perhaps slam the breaks on the economic recovery.
This is a relatively common concern: that if the Fed isn't careful inflation may rise, forcing it to jack up interest rates and crash the economy. But why would the Fed have to crash the economy if inflation rose above target? It's possible Mr Plosser, and others who share his view, are simply arguing that the Fed is not very good at its job and will dramatically overreact, raising interest rates far higher than necessary out of sheer incompetence.
It seems more likely, however, that this camp does not think crashing the economy is an error, but rather that it is what one does to wipe out inflation. That is, the experience of the early 1980s is burned deep into their minds. When Paul Volcker wanted to rein in high inflation, he had to push interest rates into double digits, touching off a nasty recession in the process. This is the way the economy works, many seem to reckon: beating inflation means jacking up rates and choking off growth until price-growth slows.
But this is deeply mistaken. The economy today is facing very different circumstances than the economy of the early 1980s, and it is extremely troubling that key policy-makers seem not to understand this.
What's different? There are three significant ways in which now is not like then. The first is simply the extent of inflation in the system. The price level rose 61% from 1977 to 1982 and 129% from 1972 to 1982. Over the past five years, by contrast, the price level has risen just 11%, and just 26% in the last ten. Prices were rising more each year in 1979 and 1980 than they rose over the whole of the last half decade. To think that the Fed would or should react to 3% or 4% inflation as Mr Volcker did in trying to cool annual inflation rates of 12% to 14% is absurd.
Second, Mr Volcker was working in an economy that was structurally very different. In the late 1970s more than 20% of private-sector workers were union members, compared to just over 5% today. Many more workers were on labour contracts with wage adjustments linked directly to inflation. That meant, first, that there was a high level of pass-through from inflation to wage growth and then back to inflation. It also meant that inflation was very persistent, since wage contracts were not easily or frequently renegotiated.
Third, and relatedly, it was not clear to many observers in the early 1980s that the Fed couldreduce inflation, because of those "cost-push" pressures, while today it is taken for granted that the Fed can and will keep inflation at very low levels. Public doubt in Mr Volcker's ability to reduce inflation meant that much of the work of disinflation had to occur mechanically, through the creation of high levels of unemployment, rather than through a simple reset of expectations. Today the dynamic is completely different. Because the Fed's control over inflation is so well-established, inflation will tend to revert to target despite tightening conditions in labour markets: that's what it means for expectations to be "well-anchored".
The Fed simply does not need to strangle the economy any more to get inflation to come down. In each of the last three business cycles the Fed's policy rate has topped out at progressively lower levels, and the ensuing recessions were short and mild—until the last one, at which the policy rate fell to zero, which takes me to a last point.
Worrying about high inflation is particularly crazy given the current state of the American economy. On the one hand, it smacks of a no-one-goes-there-because-it's-too-crowded kind of thinking. The economy has been in a nasty slump for more than six years now, during which time growth, employment, and wages have all fallen well below trend. A bit of inflationary pressure would mean that at long last the economy would be operating near potential. We should welcome and celebrate that, not fret about it.
But on the other hand, a period of sustained inflationary pressure would be most welcome because it would ultimately lead to higher nominal interest rates. If the Fed overreacted to the slightest uptick in inflation it would guarantee that interest rates in this cycle peaked at a very low level—nowhere near the 5.25% peak for the fed funds rate in the last expansion, for instance. That, in turn, would ram the American economy right back up against the zero lower bound on nominal interest rates, and that would force the Fed either to accept a deeper and longer downturn than it would prefer, or to go back to unconventional policy. Mostly likely a bit of both.
America is about the enter its sixth year of recovery. Looking back at the history of American business cycles, only 15% of expansions made it to a sixth year. Right now, markets anticipate that the fed funds rate will be just 1% when the recovery enters its eighth year. Only three expansions in America's history saw an eighth year.
To be plain: either America will have a sustained period of inflation above 2%, or America will be relying on unconventional monetary policy for the foreseeable future. It's as simple as that. It is fine for people to complain about the Fed falling behind the curve, but they should realise what they're saying. They are insisting that the American economy establish a new normal, in which interest rates are perpetually at or near zero and unconventional monetary policy becomes the Fed's main policy instrument.