A tight squeeze

There is still a case for Fed patience, despite stubbornly high inflation

Having argued so forcefully that the Fed would be advised to remain patient, it seems appropriate that I should reckon with the latest inflation figures. The consumer-price index rose 7.5% over the year to January, and the monthly rate of increase did not show a deceleration relative to December. A hefty chunk of the January rise came from the usual suspects; food, energy and shelter costs were up, as were used-car prices—for some reason Americans are determined to buy more vehicles and aren’t about to be discouraged by a measly little 40% annual increase in their cost.

But the price increases were unmistakably broader in nature in January than they have tended to be over the past year. And it is worth asking whether the Fed isn’t making a rather different mistake from the one I warned about a few weeks ago.

There are a few reasons to remain relatively relaxed about price pressures. Omicron really took a toll on parts of the food supply chain, leading to bare grocery shelves and rising prices, but conditions are improving as case numbers tumble. While there have not yet been substantial improvements to broader indicators of supply-chain problems, it does increasingly seem as though the corner has been turned. Lots of indicators, from retail sales growth in America to shipping times from East Asia, remain at levels which are historically high but below recent peaks. The last round of purchasing managers’ index data releases suggested that manufacturers in a number of countries are experiencing weaker demand. 

In addition, the latest US jobs report showed that labor-force participation rose by more over the past year than we thought, which suggests that we should perhaps be a little less pessimistic about how many people will return to work post-pandemic. And while extremely low levels of housing inventory have contributed to soaring prices and rents, the pipeline of new homes under construction is currently at the largest level since 2007. That, in concert with higher mortgage rates (which have jumped by more than half a percentage point in the past month or so alone) could contribute to a sharp slowdown in housing-cost growth as the year rolls on. 

But on the other hand, energy prices have not fallen as much as we might have hoped, and high energy costs have not depressed durable goods consumption in America as much as might have been expected. In addition, wage growth has remained quite strong. That’s a good thing, to be clear. But in the context of strong demand overall and a shift in the composition of spending back toward services, robust wage growth could translate into a disconcerting loop of wage and price growth in the absence of sufficiently credible policy by the Fed. 

Comparisons to the 1970s are still a little absurd, it seems to me. As I’ve tried to emphasize, it’s important to maintain a sense of perspective, difficult as that is in the current media environment. It has not yet been a year since annual inflation first rose above 2%, and the past year has been one of severe Covid outbreaks and supply-chain bottlenecks. Furthermore, growth in real output and employment over the past year have been absolutely on fire. This has not been a stagflation economy; it is, rather, one in which policy facilitated an extremely rapid economic recovery, for which we’ve paid an (in my view worth it) price in inflation.

But the important question now is what the Fed ought to do. And despite the latest inflation figures, my view hasn’t changed all that much from the last inflation dispatch. The most recent numbers did not lead to a sharp increase in markets’ expectations of inflation over the medium run. The yield on the 10-year Treasury bond did rise above 2% after the report. But that is still a very low number. Indeed, the most significant movement in bond yields over the past week has been a substantial flattening of the yield curve: markets are expecting much higher rates in the short-run, but not in the long run.

Policy needs to get tighter, but it seems to me that a big acceleration of the tightening timetable is very likely to invert the yield curve—to push short-term rates above long ones—and push the economy uncomfortably close to recession. And that’s assuming that it doesn’t cause intense financial stress elsewhere in the world, as it is very likely to. As wild as the past two years have been, markets don’t seem to think that we’re in a fundamentally different world now, in which central banks have to work much harder to keep a lid on price pressures, such that interest rates are persistently higher than they’ve been over the past decade or so. If they’re right (and I think they are) then the level of inflation-adjusted interest rates which the economy can withstand without sinking into recession hasn’t gone up all that much, and so a rapid pace of tightening could quite easily cause the Fed to overshoot that mark—particularly if inflation expectations start falling while interest rates are rising. 

Slower tightening would mean a longer period of above-target inflation, and the inflation that we’ve had over the past year already fits…uncomfortably within the Fed’s existing framework. I think it was appropriate, given the unique and trying circumstances we faced last year, for the Fed to disregard its framework. And I don’t think it would be a particularly good idea to push for a rapid reduction in inflation to 2% (or indeed below that) this year—because that might well require the Fed to induce a recession, and because it seems very likely that the effort would push long-run inflation expectations well below 2%.

At the same time, it strikes me as unhelpful to have in place a framework that is then more or less ignored. I understand why the Fed might be reluctant to change its framework; it is generally change averse, and it may worry that introducing a new framework while inflation is high could invite doubt as to its commitment to long-run price stability. But how helpful is the current framework, really, in communicating Fed goals? Why not make a virtue of this overshoot and take the opportunity to raise the inflation target?

It’s worth reiterating once more that the 10-year breakeven inflation rate is about where it was in 2013 and in the years prior to the global financial crisis. That level very clearly wasn’t high enough to allow the US economy to stay well clear of the zero lower bound on interest rates. We should be able to walk and chew gum here, and observe that while inflation is too high now, our problem over longer time horizons—one which markets do not think has gone away—is too low a level of inflation and interest rates. Aggressively tackling current inflation without regard to that latter problem will land us right back where we were in the early 2000s or the early 2010s.

There is another CPI print before the next Fed meeting, and if that report is similar to this one then the Fed will have little choice but to hike faster than it suggested it would at the last meeting. (Although who knows; an invasion of Ukraine might mean we have a very different economic situation on our hands.) For now we don’t need to exaggerate the costs of patience, or talk ourselves into giving up the employment and output ground that we’ve won.