In the decades since the 1970s oil-price shocks sent inflation soaring and shackled economic growth, price stability was maintained even when growth was robust. Many policymakers and economists took a bow, proudly claiming that they had found the magic formula. Underpinning the so-called Great Moderation were independent central banks that could anchor inflationary expectations by credibly committing to raise interest rates whenever inflation reared its ugly head - or even act preemptively when necessary. Independence meant that central banks need not - and typically did not - worry about balancing the costs (generally lost output and jobs) against any putative benefits.
But this conventional wisdom has always been challenged. Because interest-rate hikes achieve their intended outcome by curtailing demand, they don't "solve" inflation arising from supply shocks - such as sharply rising oil prices (as in the 1970s and again today) or the kinds of supply-chain blockages seen during the COVID-19 pandemic and in the wake of Russia's war in Ukraine. Higher interest rates will not lead to more cars, more oil, more grain, more fertilizer, or more baby formula. On the contrary, by making investment more expensive, they may even impede an effective response to supply-side problems.
The 1970s experience offers some important lessons for the current moment. One is that large increases in interest rates can be very disruptive. Consider the Latin American debt crisis in the 1980s, which had lingering effects lasting almost two decades. Another lesson is that "soft landings" piloted by central banks are especially difficult to orchestrate.
Today, much of the public debate is focused on assigning blame for the increase in inflation. Pundits are arguing over whether the US Federal Reserve should have acted sooner, and whether the government should have spent less in response to COVID-19. But such questions are not particularly on point. Given the scale of the recent supply disruptions stemming from China's stringent lockdown, the semiconductor shortage, production problems in baby formula and hygiene products, and the war's effects on grain, oil, and fertilizer supplies, inflation was inevitable.
Moreover, the sharp growth in corporate profits suggests that increased market concentration may be an important factor in the current inflation. Though the precise causes of higher corporate profits are not entirely clear, there is no dispute that they have indeed risen during the pandemic. And when serious supply constraints arise in markets, as has been the case in many sectors over the last two years, companies with considerable market power will be better positioned to take advantage of the situation.
It is easy for those who are out of office to blame those who are in office - that is the nature of politics. But President Joe Biden and congressional Democrats are no more to blame for inflation in the United States than is European Commission President Ursula von der Leyen in the European Union or Prime Minister Boris Johnson in the United Kingdom. Does anyone outside of Donald Trump's cult of followers really believe that the US would have been spared from today's inflation if only Trump had been re-elected?
The Wrong Side of the Equation
The relevant question, now that inflation is here, is what to do about it. Interest rates that rise high enough will indeed dampen price growth, but they will do so by killing the economy. Yes, some advocates of higher interest rates claim that aggressively fighting inflation will help the poor, because wages are lagging prices (which implies, of course, that wages are not driving but rather dampening inflation). But nothing is harder on workers than having no income and reduced bargaining power, which is what will happen if the central bank engineers a recession. And this is especially true in the US, which has the weakest social-protection system among advanced economies.
To be sure, some normalization of interest rates would be a good thing. Interest rates are supposed to reflect the scarcity of capital, and the "correct" price of capital obviously is not zero or negative - as near-zero interest rates and very negative real (inflation-adjusted) interest rates would seem to imply. But there are substantial dangers in pushing rates too high, too fast.
For example, it is important to recognize that US wage growth has slowed sharply, from an annualized rate of over 6% in the fall of 2021 to just 4.4% in the most recent period. (Annualized rates compare three-month averages. The most recent period compares hourly wages in March, April, and May, with December, January, and February.) So much for the "wage-price spiral" that previously had everyone scared and fueled demands for rapid monetary-policy tightening.
It is also important to recognize that this development runs completely counter to the standard Phillips curve models, which assume an inverse relationship between inflation and unemployment over the short term. The slowing of wage growth has occurred at a time when the unemployment rate is under 4% - a level below anyone's estimates of the "non-accelerating inflation rate of unemployment." This phenomenon may owe something to the much lower level of unionization and worker power in today's economy; but whatever the reason, the sharp slowdown in wage growth indicates that policymakers should think twice before generating further increases in unemployment to tame inflation.
The Fed's rate increases have already had a large impact on the US economy. Mortgage rates jumped from around 3% last year to around 6% following the latest hike, and this sudden increase in borrowing costs has massively altered the shape of the housing market. Purchase mortgages have fallen by over 15% year on year, and the refinancing market has virtually shut down, cutting off an important source of credit for millions of households and auguring a wave of layoffs in the mortgage finance industry. According to the most recently reported figures, housing starts (new-home construction) in May were down 7% from the previous month.
Contrary to claims by many analysts, households still are not spending down their savings to any substantial extent. The widely reported drop in the saving rate in recent months reflects neither additional consumption nor a decline in income, but rather an increase in the amount of capital-gains taxes people are paying. Tax collections reported for the month of May were more than 40% above their 2019 level. If we combine savings and tax collections, the 19.1% rate for May is actually above the 18.6% average for 2018 and 2019.
With real consumption running at a normal level, there is little reason to believe that the US economy has a serious problem of excess demand. Making matters worse, higher interest rates and their effects on housing markets are likely to prove counterproductive. After all, rents are an important component of the consumer price index, and they have been rising sharply, owing partly to a shortage of supply. Now that the housing supply is taking a new hit from higher mortgage rates, any near-term benefit in the form of reduced demand will be partially offset by higher housing costs.
This example points to a larger issue, because many of the key dimensions of today's inflation, such as food, housing, energy, and car prices, are likely to respond only to moderately higher interest rates. For example, purchase mortgage applications have already fallen by more than 20% from their levels a year ago, and reductions in house-listing prices have become widespread. Nonetheless, there is a temptation to increase interest rates too much and too fast, which is why there is now widespread fear of a looming recession.
Yet for all the din and roar over inflation and the monetary-policy response, there is less disagreement than one might think. Most commentators on both the left and the right believe that interest rates should be increased. The controversy stems from questions such as when we should worry that rates are increasing too much and too fast, and how preemptive we should be.
Inflation hawks want to raise interest rates until either inflation becomes muted or the pain of increased unemployment and lower growth becomes too great to bear (and even then, they will complain about a lack of nerve). By contrast, those more concerned with the real economy and ordinary workers argue for a gradualist approach, whereby significant tightening would be withheld until there is evidence of a significant acceleration of inflation.
In navigating this divide, we should remember that today's economy is very different from the economy of the 1970s. It would be the height of foolishness to graft 1970s solutions onto the problems facing us in 2022. The economy is very different: globalization is more far-reaching and unions are significantly weaker. Accordingly, the debate should be turning to what else the government can do both to tame inflation and manage its most adverse effects, and to which political and economic ideas are most likely to guide us to the objectives we seek.
Even most of those who have complained about excess demand recognize that today's inflation is driven largely by supply-side disruptions, and that while none of the shocks could have been predicted with much precision, the private sector has failed badly. Short-sighted behavior (of the kind we saw in the run-up to the 2008 financial crisis) has again imposed enormous costs on society. In a turbulent world beset by multiplying risks, our economies are utterly lacking in resilience. Worse, many of these risks were foreseeable - and, indeed, foreseen. Consider Europe's excessive reliance on Russian gas. Many economists had warned about the dangers of a lack of diversification - especially as market concentration in the energy sector continued apace. Russia is now brutally vindicating thjose warnings.
While some recent shocks would have happened no matter what, their effects have been exacerbated by a political and economic philosophy that puts corporate interests and "market-based" solutions first. Many of today's biggest problems - and their consequences for ordinary citizens - can be addressed only by concerted collective action. They call for government policies aimed at circumscribing concentrations of market power and encouraging greater diversification and more long-term thinking (through tax structures and corporate-governance laws), and for industrial strategies that recognize the importance of borders and the real risks we face. Eyes on Supplies
Supply-side constraints call for supply-side solutions, many of which have yet to receive proper attention. Such measures would do as much to tame inflation as limited increases in interest rates would, and they would not come at the expense of workers and the broader economy.
To address labor-supply issues, policymakers should be considering immigration reform, investments in childcare, a higher minimum wage, and legislation to make the workplace more attractive, especially to women and the elderly. To fix the housing sector, we need to encourage conversions of vacant office space into residential units. To tackle the energy crisis (and future ones), we need much greater public investments in green energy and government price guarantees on oil - a policy mix that would encourage production when there are shortages while still phasing out fossil fuels over the longer term. We also need stronger competition laws, so that firms don't have an incentive to curtail production as a way to juice their profits.
Most importantly, we need to help those at the bottom and middle cope with the consequences of inflation. Because the US is close to being energy independent, the country as a whole is relatively unaffected by changing energy prices (gains to exporters are simply offset by importers' losses). But there is a huge distribution problem. Oil and gas companies are raking in windfall gains while ordinary citizens struggle to make ends meet. An "inflation rebate," financed by a windfall-profits tax on fossil-fuel corporations, would efficiently address these inequities.
Today's inflation has produced big winners and big losers, with the winners being concentrated at the top of the income and wealth distribution, and the losers at the bottom. It doesn't have to be this way, nor should it be any longer.
