The latest inflation report points to a hard truth: The US is not going back to a 2% inflation rate anytime soon. At least not easily.
It’s clear, as inflation picks up and real wages continue to fall, that the period of smooth disinflation is over. The reasons could be government policy — on trade, immigration or energy — but for the consumer or the Federal Reserve’s credibility, none of that matters. The US economy is built for 2% inflation, Fed Chair Kevin Warsh has promised to reach that target, and the rate of inflation is higher than that.
The Fed has some tools to reduce inflation. The question is whether it is willing to use them. A rate hike or two, which the market is already anticipating, probably won’t be enough to do the job.
Here’s why: If inflation is up because of high demand and a hot economy, a few rate hikes can increase the cost of capital and signal the Fed’s commitment to fighting inflation. This will have the effect of tempering expectations and, ideally, reducing the rate of inflation.
But that is not the situation in which the US economy now finds itself. Current inflation is the result of supply factors the Fed does not have much control over, such as in the energy market. The deflationary forces that existed in the 2010s — a younger population and more trade — no longer hold. Expectations are also less stable after years of high inflation.
See more: Hike or Hold? Debating the Coming Fed Decision
In other words, if the Fed wants to meaningfully lower inflation, it may need to depress demand to compensate for supply issues while also sending a strong signal that it is serious. That could take several hikes. Reducing demand would require increasing the cost of capital, bringing down the stock market. If the downturn is severe, it could cause more unemployment or even a recession.
This is what former Fed Chair Paul Volcker had to do. At the time, the Fed’s credibility was weak. What became known as the Volcker shock, when the Fed raised rates to almost 20% in the early 1980s, proved the Fed’s mettle. Inflation stayed low for decades on the belief that the Fed would do what it takes.
Fed governors still talk tough on inflation. But they don’t always act that way: The Fed cut rates nearly two years ago, when inflation was still elevated. It is hard to imagine Warsh raising benchmark overnight rates above 6% from the current range of 3.5% to 3.75%, especially once the economy starts to hurt. Not only does he face more political pressure from the president, but he may also face public resistance.
More Americans own stock than they did in the 1980s, with the Fed reporting that US household net worth soared by a record $12.8 trillion in the second quarter in part because of the rising value of equities. A big drop in the market would bring lots of wealth destruction — just as many people could be losing their jobs.
What Volcker did was unpopular at the time — and when he began his tenure, the inflation rate was 10%. Would the public really tolerate going into a recession to get inflation from 3% to 2%?
It is a dilemma for the Fed. An inflation rate of 2.5% to 3% is not ideal, especially if wages aren’t keeping up (though it is better than the alternative of risking a recession). But if the Fed keeps saying it is serious about a target and the US never reaches it, the central bank loses credibility. If there is another big inflation shock, it may take longer, and even higher rates, to bring it down.
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