- Paul Krugman fears the Federal Reserve could go overboard in fighting inflation.
- He pointed out that rate hikes have a delayed effect and highlighted signs of a slowdown in the labor market.
- The economist predicted that interest rates would eventually return to near zero without causing inflation.
Paul Krugman has warned that the Federal Reserve risks going too far in controlling inflation and causing unnecessary economic damage. The Nobel Prize-winning economist has also predicted an eventual return to near-zero interest rates once inflation is brought under control.
The Fed may have done enough
“I don’t think many people appreciate how quickly the economy — both labor markets and inflation — can turn,” Krugman said in one Twitter thread On Wednesday.
The economist noted that monetary tightening effectively started earlier this year as long-term interest rates rose in anticipation of Fed rate hikes. The US Federal Reserve has since hiked interest rates from near zero to a range of 3% to 3.25% and has signaled it could hike to over 4.5% in the spring.
With long-term interest rates lagging behind, the US economy “is only at the beginning of a major Fed-induced slowdown/contraction,” Krugman said.
The Nobel laureate also highlighted employment data released on Tuesday, which showed a sharp decline in the US job vacancy-to-workforce ratio to 1.7 to 1 in August. The available labor force was outstripped by two to one, pushing up wages and adding to inflationary pressures.
Krugman argued the data was clear evidence of a cooling economy, noting that two more monthly declines of the same magnitude would bring this ratio back to pre-pandemic levels.
“That was the best economic news I’ve seen in a long time,” said the economist tweeted Tuesday.
He said there was a significant risk that the central bank would overdo it in containing inflation, given the lagged impact of higher interest rates and signs of a weaker labor market that could ease upward pressure on wages.
“Yes, the Fed was behind the curve on rising inflation,” Krugman tweeted. “But I’m concerned that we might re-enact the old joke about the driver who hits a pedestrian, then tries to fix it by backing up – and hits the guy a second time.”
Lows could return
Krugman predicted in a New York Times column on Tuesday that interest rates would return to near zero once the inflation battle was over.
The economist stressed that interest rates drifted towards zero over the three decades leading up to the pandemic, but this did not translate into serious inflation.
He suggested that the “natural rate of interest” may have fallen due to lower investment demand, a reflection of weak US labor force growth and a lack of innovation since the 1990s. Those trends could weigh on investment in homes, appliances, office space and new equipment, he said.
Meanwhile, Krugman argued that inflation has only soared during the pandemic because government aid has bolstered consumer spending power. Meanwhile, lockdowns and supply chain disruptions constrained the economy’s productive capacity and pushed up prices.
He suggested that both of these forces would prove temporary and therefore interest rates would eventually return to pre-pandemic levels without causing significant inflation.
“It’s hard to imagine that once the inflation spike is over, the natural rate will increase,” he said. “The era of low interest rates is probably not over yet.”