The Fed Has to Stay the Course Against Inflation

A growing chorus is urging the Federal Reserve to slow down lest it “break things”. If you’re paying attention, you should be nervous about mounting financial strains in the US and around the world. But underlying US inflation is worse and employment stronger than when the Fed announced tapering in November 2021. Until there is tangible progress on inflation, rather than wishful thinking, the Fed should not back down – a process that could easily push the federal funds rate above 5% next year.

Those urging the Fed to slow down make four reasonable but unconvincing arguments. First, monetary policy works with long and variable lags. Allow the medication already administered to work before further increasing the dosage. A problem with this view is that two-thirds of the tightening, as measured by Goldman Sachs’ Index of Financial Conditions, actually happened more than five months ago. Many tightenings are already working, but they’re not doing enough.

More importantly, the Fed’s favorite price index, personal consumption spending, or PCE, has risen at a 5% annual rate over the past three months. Of even greater concern, this rate has been kept low by volatile technical factors such as the sharp fall in the notional price of investment advice, a component of the index, despite no one actually paying, reflecting falling assets. The more reliable median PCE price index grew at an annual rate of 6.9% over the same period. Both are higher than when Chairman Jerome Powell made his first pivot in November 2021.

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Inflation has persisted and is strengthening, although many of the factors that are said to have been driving it up have improved, including rapid supply chain repairs, ample inventories, rising labor force participation, falling energy prices and an economy increasingly less affected by Covid is affected.

Optimists point to signs that inflation will moderate. The latest signal is the sharp drop in job vacancies, but there are also falling house prices, falling shipping costs, falling commodity prices, employer surveys forecasting slower wage growth and falling inflation expectations. However, despite recent improvements, labor markets are still much tighter than at any point before the pandemic, and many of the other commonly cited factors have little or uncertain relationship to inflation. Many other signs point in the opposite direction, including the fact that certain special factors that are dampening inflation – such as imputed investment advisory fees – are unlikely to continue to do so. Wage inflation has picked up over the year and rents on existing leases remain well below rents on new leases.

The second argument in favor of slowing down or hiring is the cost of doing too much — and plunging the economy into an unnecessary recession. That, too, is reasonable – but there are also significant risks involved in doing too little. When inflation or inflation expectations rise, the cost of solving the problem rises. The costs the economy is facing today are partly due to too little being done in the past year. It would be a shame to continue the same mistake.

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The third argument is that the Federal Reserve is “destroying” financial markets. Tensions have arisen everywhere. Stock markets are down, the dollar is strong and liquidity in credit markets is drying up. However, most of this is consistent with what the central bank is trying to achieve. A stronger dollar lowers import prices and slows the export sector. Higher interest rates slow corporate and household borrowing. Lower share prices reduce consumption. These are not the unintended credit market problems of fall 2019. What is happening now is largely what the Fed intends and is necessary to curb demand and lower inflation.

Unrealistically optimistic expectations are themselves the greatest risk to financial markets. The market rally in the first half of August felt good but was based on an overly rosy understanding of the economy and the Fed’s response to it. Those expectations collided with reality in the form of Mr. Powell’s Jackson Hole speech and the August inflation data. Markets now appear to be pricing in inflation at around 2% next year, leaving them with a large one-sided risk of inflation staying above that rate. It’s far better for the Fed to prime markets for the worst with expectations of higher interest rates so they can relax when the data shows that inflation is moderating.

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The final argument is that the strong dollar and high US interest rates are wreaking havoc around the world, exporting inflation, forcing countries to raise their own interest rates more than they would like, and leading to capital outflows. These conditions make debt repayment by emerging and developing countries more difficult. There is a certain sad truth to all of this, although it should not be exaggerated. The problems most countries face stem from their own domestic politics and high commodity prices, particularly natural gas in Europe. More importantly, the Fed’s mandate is to focus on the US economy, not the global economy. The reality is that the problems of the world are unlikely to spill back on the US in an unwelcome manner, especially if our main goal is to reduce demand.

The Fed should be looking around every corner. She should be worried about the state of the world economy. But for now, the data is telling a crystal clear and consistent story: Very tight labor markets are keeping inflation well above the Fed’s target. Until actual inflation begins to fall, the Federal Reserve should not even consider changing course. Fortunately, the Fed is acting smarter than its legions of critics.

Mr. Furman, Professor of Economic Policy at Harvard University, served as Chair of the White House Council of Economic Advisers from 2013 to 2017.

Review and Outlook: Inflation is proving to be much more durable than Joe Biden’s financial advisors had hoped, with Labor Department data confirming the Fed’s determination to move on. Images: Getty Images Composite: Mark Kelly

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