Inflation is painfully high, and the Fed has to walk a tightrope
The conditions for inflation to moderate are in place now. But this is also where some good luck comes in.
The economy is struggling. Unemployment is low and there are plenty of jobs, but inflation is painfully high. Too high. Unsustainably high. Inflation must moderate soon, or the economy will suffer a recession. How the Federal Reserve manages interest rates is critical to how this plays out.
The Fed has a difficult task. Policymakers must raise interest rates high enough, fast enough to rein in runaway inflation. But it must not hike too far, too fast and precipitate a downturn. It won’t take divine intervention for policymakers to walk this tightrope, but it will take some good luck.
At more than 9% in the last year, this painful inflation is the highest in two generations. The typical American household must spend nearly $500 more per month to buy the same goods and services it bought last year, including essentials such as gas, food and rent.
High inflation is corrosive, ultimately undermining economic growth and resulting in high unemployment. The Fed desperately wants to avoid this dreaded high-inflation, high-unemployment affliction, which is known as stagflation.
Fed Chairman Jay Powell often channels former Fed Chair Paul Volcker, who ended the stagflation of the 1970s and early 1980s by jacking up interest rates. Powell is following the same playbook by aggressively raising rates. On Wednesday, the Fed increased the federal funds rate, the interest rate it directly controls, by a stunning three-quarters of a percentage point on top of a similar hike just a few weeks ago.
And policymakers have signaled that they plan to keep on raising rates in the coming months.
Slamming on the brakes
You’re probably wondering how we got into this mess. Why didn’t the Fed raise rates more quickly when inflation began to significantly pick up more than a year ago, so it wouldn’t have to slam on the monetary brakes so hard now?
Policymakers clearly misjudged. But it is hard to blame them. For the decade after the financial crisis and through the pandemic shutdowns, inflation was much too low for comfort. High inflation is a problem, but so is too-low inflation. Policymakers viewed the revival in inflation this time last year as a chance to get inflation firmly up to their 2% target.
And they likely would have gotten what they wanted — if not for COVID-19. When the vaccines were rolled out last year, most of us thought the pandemic would quickly fade away.
» READ MORE: What it means for you now that the Fed’s raised interest rates — again
Of course it didn’t, and wave after wave of the virus continues to disrupt global supply chains, causing shortages and higher prices. Many workers are still sidelined because they are sick with the virus, dealing with its long-term health effects, or taking care of sick family and friends.
Also shocking was the Russian invasion of Ukraine. It wasn’t on anyone’s radar screen a year ago. But it has done serious economic damage, roiling oil, natural gas and agricultural markets and causing prices to surge.
Record high gasoline prices have been especially pernicious. They’ve significantly contributed to a jump in inflation expectations — what we believe inflation will be in the future. If workers believe inflation will remain high for the long run, they will demand higher wages to compensate, and employers will oblige, believing they can pass along higher labor costs to their customers by raising prices. A vicious wage-price spiral threatened to take hold.
Where good luck comes in
The prospect was too much for policymakers to bear. Powell has made it clear the Fed will raise interest rates as high as required to quell inflation. This means cooling off economic growth, short-circuiting any wage-price spiral, and nailing down inflation expectations. If needed, it may even mean sacrificing the economy to recession.
That sacrifice shouldn’t be necessary. The conditions for inflation to moderate are in place now. The economy is throttling back, wage growth appears to have peaked, and inflation expectations have receded to near the Fed’s target.
But this is where some good luck comes in. The pandemic must continue to fade, allowing scrambled supply chains to steadily iron themselves out and getting those sidelined workers back on the job. The worst of the economic fallout from the Russian invasion must also get behind us. The most crucial thing of all is that oil prices have peaked.
These are the most important known unknowns. The economy must also be lucky enough to avoid a long list of unknown unknowns. Example? A Category 5 hurricane slams into the Texas coast and takes out a refinery for a few weeks. Gas prices surge. In most times, that might register as a nuisance. Right now, it could be too much for the economy to withstand. I’m not forecasting such a thing, but you get my drift.
On second thought, some divine intervention would certainly come in handy.
Mark Zandi is chief economist for Moody’s Analytics.