“Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labour market conditions that benefit all.” Thus did Jay Powell, chair of the Federal Reserve, open his press conference after the meeting of the Federal Open Market Committee on November 2 at which it was decided to raise the rate on federal funds by 0.75 percentage points to 4 per cent. He was right. It is the duty of the state to ensure that its money has a predictable value. Central banks are entrusted with this task. Recently, they have been failing badly. It is a necessity and an obligation to rectify this failure.
Between September 2019 and September 2022, headline levels of consumer prices, which are the ones relevant to people, rose 15.6 per cent in the US, 14.1 per cent in the UK and 13.3 per cent in the eurozone. If central banks had hit their targets, these price levels would have risen just over 6 per cent.
There are good excuses for this failure, notably the disruptions caused by Covid-19 and then Russia’s war on Ukraine. Yet the outcome is not just due to supply shocks. In the three years to the second quarter of 2022, nominal demand expanded 21.4 per cent in the US, 15.8 per cent in the UK and 12.5 per cent in the eurozone. This is equivalent to compound annual growth of 6.7 per cent in the US, 5 per cent in the UK and 4 per cent in the eurozone. These rates of growth of demand are simply inconsistent with 2 per cent inflation in these economies, especially in the US and UK.
Not so long ago, many worried that inflation had been too low for too long. In August 2020, the Fed duly announced a new “Statement on Longer-Run Goals and Monetary Policy Strategy”. In this it stated that “following periods when inflation has been running persistently below 2 per cent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time”. It is hard to argue that the subsequent inflation overshoot has been “moderate”. More importantly, it has transformed the history. In the US and UK, the price level increase over the past decade is equivalent to a compound annual increase of 2.5 per cent. At the end of this decade, that level is some 6 percentage points higher in both countries than it would have been if the price target had been hit. Yet people are not arguing that symmetry now demands sub-target inflation, maybe at 1 per cent for six years. In the eurozone, in contrast, inflation over the past decade is now back to the target of 2 per cent.
The idea that one should correct for bygones was not sensible. But if people conclude that central banks will only offset past low inflation, not past high inflation, and that inflation shocks are more probable than deflation shocks, too, they might reasonably conclude that inflation will not average 2 per cent. This view will be reinforced by the fact that central banks adopt ultra-loose policy more enthusiastically than they do the reverse. In sum, people will think that they have a clear inflation bias.
This is not just ancient history, far from it. It ought to shape what central banks do now. This is particularly true in the US, where the contribution of presumably temporary rises in energy and food prices is smaller than elsewhere and so the domestic factors in inflation are far more important.
This history strengthens the already strong case for getting back to the target sooner rather than later. Thus, the longer inflation remains high, the further the price level will go above what it should be and so the bigger the cumulative losses for those who trust the stability of money. This will stoke anger. It will also make it more essential for the losers able to do so to recoup their losses. That will make wage-price and price-price spirals more durable. Furthermore, the longer inflation remains above target, the more likely inflation expectations are to be fundamentally “de-anchored”. That would make the task of restoring credibility harder and the costs of doing so greater. The worst possibility of all would be not for disinflation to be done too slowly, but for policymakers to give up too quickly, making it necessary to do it all over again in even worse circumstances. That, too, will be more likely if the disinflation is too long drawn out.
Against this, it will be argued that there are risks of creating financial turmoil and an unnecessarily deep global recession, possibly even tipping economies into Japanese-style chronic deflation. This is indeed a danger. It is why the scale and duration of past fiscal and monetary support was a mistake, especially in the US, as Lawrence Summers of Harvard has long argued.
Yet it is hard to argue that an interest rate of 4 per cent is too tight in an economy with a core inflation rate of 6.3 per cent. This is even truer of the Bank of England’s 3 per cent and the European Central Bank’s 2 per cent. If the US and global financial systems cannot survive even these low rates, they are in unforgivably bad shape.
Past policy mistakes have interacted with a series of big shocks to generate high inflation. Those mistakes are real and significant, however. It is noteworthy, for example, that comparable shocks to energy and food prices in the early 2000s did not generate inflation as high as today’s in the US. Aggregate demand has also been unsustainably strong, again especially in the US. This has to be corrected, both firmly and fast, if the foundations of renewed growth are to be laid. The risks of tightening are real. But those of letting inflation become entrenched are greater. As Macbeth says, if one has to do something hard, “’twere well / It were done quickly.”
martin.wolf@ft.com
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