Lenin Nolly/Sipa USA via AP Images
Federal Reserve chairman Jerome Powell speaks about the economy and the changing labor market on November 30, 2022, at the Brookings Institution in Washington.
The Federal Reserve is expected to raise interest rates again when its Federal Open Market Committee concludes its two-day December meetings on Wednesday. Rumors that the Fed will hike short-term rates by “only” half a percentage point, rather than the three-quarters of a point of each of its last four meetings, are being taken as good news.
In the meantime, however, careful economic evidence is accumulating that the Fed’s policy is based on bad economics. The central bank is needlessly trying to push the economy into recession when inflation is already subsiding for reasons that have almost nothing to do with the recent rate hikes. Paradoxically, the underlying economy is so resilient that we may avoid the recession and needlessly high unemployment that Fed chair Jay Powell’s actions are enabling, egged on by hawks like Larry Summers.
The basic Fed story, flogged relentlessly by Summers and accepted by Powell and a majority of Fed governors, is that $3 trillion of anti-recession spending, especially the $1.9 trillion American Rescue Plan, overstimulated the economy and generated price pressures. Research has demonstrated that this claim is wrong, on several grounds.
First, as the Prospect documented in our special issue on supply chains, most of the economy’s bottlenecks were the result of various pandemic disruptions, interacting with global supply systems that were too fragile to begin with. Global manufacturing was far too reliant on China. When China took extreme anti-COVID measures, that disruption crimped its export of vital manufacturing inputs. Russia’s war on Ukraine only added to the disruption and the global price pressures, especially in energy and food.
Shortages of specialized items such as chips needed in auto manufacture cut the supply of new cars. That in turn raised the price of used cars as a close substitute.
Global shipping companies took advantage of supply shocks to raise prices. Rates averaged around $1,800 per container during the two years prior to the pandemic. They soared to over $10,000 by September 2021. Shipping company profit margins subsequently jumped from 8.5 percent in 2019 to 56 percent by the third quarter of 2021.
As supply chain pressures eased, shipping rates have gradually fallen back to about $2,400 by this November. This movement, up and then down, had nothing whatever to do with either aggregate demand or with the Fed’s tight-money policy.
It is preposterous to imagine that higher interest rates would reduce spot shortages in specialized chips, or would cause more oil to flow, or more shipping containers to materialize, or end a war. But the Fed’s theory of demand-driven inflation causes it to ignore what is really at work.
In addition to supply shocks, the economy paid the price for decades of bad policy that deregulated key domestic transportation sectors. The conditions of work were allowed to deteriorate for truckers, leading to shortages of qualified drivers. In the deregulated freight rail sector, hyperconcentrated railroad companies tore up freight yards, reduced rail capacity, and put workers on punishing schedules in order to increase capacity. When the recovery from the pandemic required more rail shipping capacity, it wasn’t there. Once again, neither the trucking story nor the rail story has anything to do with excess aggregate demand, and higher interest rates will not cause more rail lines or more truck drivers to materialize.
What really occurred during and after the COVID recession was not an excess of aggregate demand but a shift in the composition of demand.
Summers and the inflation hawks have contended that the stimulus legislation caused price pressures because it pushed the economy beyond its capacity. However, careful research by Joseph Stiglitz, Josh Bivens, and others has demonstrated that in the current recovery, actual output is below the Congressional Budget Office projection of potential output. In other words, there is no macroeconomic overheating.
Another claim was that the economic recovery produced low unemployment rates and tight labor markets, giving workers too much bargaining power. But throughout the COVID recession and then in the 2022 recovery, wage levels have lagged price levels. On average, American workers have suffered a decline of 3.1 percent in real wages over the past two years. If wages are lagging prices, it is impossible that they would be responsible for the inflation.
During the pandemic, about 8.2 million workers left the labor force. Some left because the pandemic produced layoffs, others because their working conditions were intolerable, others because of a lack of caregiving for their children. The ARP gave them the wherewithal to survive and ensured that the recession would be short. It deserves our thanks, not condemnation.
Another set of data that gives the lie to Fed policy assumptions is the inflation rates in other countries. Europe’s inflation rate, at 11.5 percent in October, was far higher than ours. But Europe didn’t have anything like the nearly $3 trillion of anti-recession stimulus of the United States. The U.S. deficit ratio was 5.5 percent in FY 2022, compared to less than 3 percent in the EU. With its disrupted energy and food markets, Europe is simply a more extreme case of supply shocks than the U.S.
A further source of price increases that has nothing to do with excess demand is opportunistic price increases by corporations with market power.
What really occurred during and after the COVID recession was not an excess of aggregate demand but a shift in the composition of demand. Some people who were working from home reduced other consumption expenditures and looked for more space. That pushed up housing costs. As people are returning to work and not seeking larger places to live, housing inflation has subsided.
By the same token, during the pandemic people tended to spend relatively less on services outside the home, and relatively more on goods. But a shift in the composition of demand is not the same as excessive demand generally. As the pandemic economy returns to something closer to normal, these sectoral price spikes are subsiding.
ONE OF THE MOST BIZARRE ASPECTS of the Fed’s policy is its relentless commitment to a 2 percent inflation target. This target, which then-Fed chairman Alan Greenspan basically made up in the early 2000s, has no basis in economic theory.
The former chief economist of the International Monetary Fund, Olivier Blanchard, recently published a piece in the Financial Times arguing that the inflation target should be at least 3 percent. Jared Bernstein of Biden’s Council of Economic Advisers observes that the Fed confuses the rate of inflation with the trend. Inflation at 4 percent would be just fine if it was not rising. Despite a lot of worry about “inflationary expectations” feeding on themselves, that is not happening in the current economy, where labor has too little bargaining power, not too much.
Getting all the way down to 2 percent will require punishing the real economy and will produce no real benefits. The only reason central bankers have for insisting on that target is “credibility.” But credibility with whom and to what end? It’s the 2 percent target that lacks credibility.
A research paper by Robert Pollin and Hanae Bouazza, discussed at a recent research conference at the University of Massachusetts Amherst, reviewed the relationship between real GDP growth and inflation for 130 countries over the period 1960–2021. They found that in countries and periods with very low inflation rates (of under 2.5 percent), real GDP growth was significantly lower than when inflation was between 2.5 and 5 percent. And real growth is actually higher when inflation increases to the range of 5 to 10 percent.
By the time the Fed’s rate increases take effect and do damage, the inflation will be subsiding on its own.
In June, Summers claimed that we need a 5 percent unemployment rate for five years to cool inflation, and that the Fed should pursue a tight-money policy accordingly. But the economy is already making a liar of him. Summers has also declared, “If you look at history, there has never been a moment where inflation is above 4 percent and unemployment is below 5 percent where we did not have a recession within the next two years.” He is likely to be disproven on that, too.
The economy shows stubborn sources of strength. The unemployment rate has stayed around 3.7 percent, and inflation is coming down on its own. Meanwhile, the economy keeps generating jobs. If the Fed doesn’t needlessly crush the economy and doesn’t religiously demand a 2 percent inflation target, inflation could subside to the range of 3 to 4 percent in 2023, growth could continue, and unemployment could stay low.
The risk is less that Summers will be vindicated than that Powell will appear to be. No less than Larry Summers declared—correctly for a change—that “monetary policy famously has worked with a lag of nine to 18 months.” So by the time the Fed’s rate increases take effect and do damage, the inflation will be subsiding on its own. With inflation subsiding for other reasons, there is a danger that Powell will claim that his policy of tight money is working, claim credit, and keep tightening.
GOING FORWARD, MOST OF THE CURES for the structural sources of inflation will take time. They include re-regulating key transportation sectors such as rail, trucking, and ocean shipping; bringing more production home; continuing the revival of antitrust enforcement, so that corporations have less market power to extract opportunistic price hikes; and complementing antitrust with excess profits taxes.
Here, there are two pieces of good news. Some of these policies are already being carried out, though we need a far more aggressive reregulation of transportation. And even without these structural reforms, if you look at the normal, pre-pandemic economy, inflation was well behaved at 2 to 3 percent. There is no reason to think that we can’t return to something like this, though it should be based on higher wages and lower corporate price-gouging.
There has been some support for higher rates on the premise that the long period of very low rates stimulated asset bubbles in stock prices and housing. Here, too, the remedy is regulatory policy, not tight money. The real economy needs low credit costs to promote productive investment. The cure for high stock prices driven by stock buybacks is to ban stock buybacks. The cure for private equity excesses is to regulate private equity. The cure for housing inflation is to build more housing. Strangling the productive economy with tight money addresses none of these ills.
As far as I’ve been able to tell, Chairman Powell does not have a “B-Team” exercise, in which economists with detailed knowledge of supply factors challenge the prevailing narrative of excess demand. Powell would rather dwell in his own echo chamber.
Biden did make one serious mistake. It was not the American Rescue Plan. It was being suckered into reappointing Jay Powell as Fed chair. Had Biden named the other leading candidate, Fed governor Lael Brainard, it is hard to believe that Brainard would have been as stubbornly wrongheaded in her economic analysis and monetary policy.
When the Federal Open Market Committee announces its policy tomorrow, Powell will hold his usual press conference. It will be instructive to see whether he has learned anything and revised his views accordingly. We’ll be watching.
