We Need to Do Hard but Necessary Things to Tackle Inflation

Students used to look at me quizzically when I mentioned the word “inflation,” as if I were reminiscing about the invention of the spinning jenny. No more. Last Friday’s Consumer Price Index report showed that inflation had grown to 6.8 percent from last November’s rate of 1.2 percent — the fastest clip in almost 40 years.

Is it time to panic? No. But President Biden and Jerome Powell, the chairman of the Federal Reserve, need to take action now.

This time last year, few forecasters predicted inflation of almost 7 percent. Yet when consumers want to buy more than the economy is producing — the macroeconomicstory of the year —it is a classic harbinger of rising prices. The Covid pandemic delivered supply shocks in the form of disrupted workforces and supply chains. This, in turn, exerted upward pressure on prices. Very low interest rates and generous government Covid relief programs, designed to cushion a fall in demand in response to the pandemic, added to demand and price pressures.

Last year, the Federal Reserve, which oversees interest rates and the nation’s banks and monetary supply, instituted a new framework. It proposed that inflation levels of higher than 2 percent, the Fed’s traditional target, could make up for the lower levels of inflation the economyexperienced in the years after the 2008 financial crisis but before the Covid-19 pandemic.

Policymakers injected three rounds of fiscal stimulus into the pandemic-afflicted economy. The most recent round sat atopstored-up households savings of at least $2 trillion, according to recent estimates. Those savings were accrued from earlier rounds of stimulus, as well as an improving labor market.A new infrastructure bill and the possible passageof Mr. Biden’s Build Back Better agenda offer additional deficit financing and a push to demand.

For much of this year, the Fed has explained that inflation would be “transitory”: Price increases would quickly decline and expectations of future inflation would stabilize. While Mr. Powell recently retired use of the term, it was never entirely clear what time interval it referred to. Many economists and business leaders worry that the Fed’s decision to overshoot 2 percent inflation has gone too far.

As supply chains normalize, inflation will almost surely moderate. But by this time next year, inflation as measured by the Consumer Price Index, the weighted average of a basket of goods commonly purchased by households, could still be as high as 4.5 percent; the core inflation the Fed emphasizes, which excludes food and energy prices, could be 3 percent.

Higher inflation is not a victimless crime. Middle-income savers and retired people on fixed incomes face danger from higher inflation. And workers whose wages don’t keep up with rising inflation are in a similar boat. In September, wages for the prior 12 months had risen 4.2 percent while consumer prices rose by 5.4 percent, according to the Employment Cost Index, a measure of the change in the cost of labor reported quarterly by the U.S. Labor Department’s Bureau of Labor Statistics.

To a great degree, Fed officials are fighting the war of the last financial crisis and recovery, a period characterized by sluggish employment growth and low inflation. That crisis was one of plummetingdemand, while the pandemic economy has been plagued by supply constraints and surging demand.

So what should policymakers do? They must acknowledge that taming inflation is likely to require reining in demand.

One part of the solution involves the Fed’s purchase of assets. These purchases are aimed at lowering borrowing costs. But the Fed kept at it even as the recovery took hold in an effortkeep the labor-market recovery humming. Particularly difficult to explain is the continuing purchase of mortgage-backed securities, even as the housing market runs white hot.

The Fed must begin tapering asset purchases more aggressively now. In recent weeks, Mr. Powell has signaled a willingness to double the pace of the taper to $30 billion a month — a move he should make in this week’s meeting of Fed officials. Such a change would ease the aggressive boost to demand the Fed has been providing through the pandemic.

The Fed should also raise its benchmark federal funds rate in early 2022. This is ashort-term interest rate at which banks borrow and lend reserve balances with one another. He should also be prepared to make further adjustments should macroeconomicconditions, including broader and longer-lasting inflation, demand it.

The Fed has argued that running the economy hot may bring more workers back into the labor force. But unemployment is already lowat 4.2 percent, and weekly unemployment-insurance claims are at their lowest since 1969.

If Mr. Powell fails to change the Fed’s course now, the current levels of high inflation will begin to affect long-term inflationary expectations. When consumers and businesses expect inflation to be high, it becomes more embedded in economic decision making — things like business investments or negotiating for higher wages. The only way to fix this would be a sharp, quick contraction in the form of higher interest rates and balance-sheet reduction. But such a sudden reversalcould spark a recession. Prudent risk management, instead, would have the Fed tightening financial conditions gradually — starting now.

As a result, monetary policy will become less accommodative. But this would be better than the more aggressive approach that could prove necessary if higher inflation persists deep into next year.

This approach to tackling inflation also means that the president and Congress must acknowledge that now is not the time for additional stimulus to demand. That means trimming Mr. Biden’s Build Back Better agenda — a plan that, as the Congressional Budget Office has reported, would raise the budget deficit if enacted.

If this gradual cooling of the economy is to work, it must start now. And both the Fed and the White House must communicate their intentions carefully.

Glenn Hubbard, a professor of economics and finance at Columbia, was the chair of the White House Council of Economic Advisers from 2001 to 2003. He is the author of the forthcoming “The Wall and the Bridge.”

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