Editor’s note: David Wilcox is Director of US Economic Research at Bloomberg Economics and Senior Fellow at the Peterson Institute for International Economics. From 2011 to 2018, he was the director of the home economics division of the Federal Reserve Board. The opinions expressed in this comment are his own. See more reviews on CNN.
Rising prices are causing real and immediate financial hardship for millions of American households. While a growing number of economists argue that the Federal Reserve has gone too far in its fight against inflation and is unnecessarily setting the US economy into a hard landing, I would argue that the Fed is doing what it needs to do to fulfill its responsibility to control inflation. even if doing so means risking a recession.
The higher inflation rises, and the Fed’s efforts to control it are resisted, the tougher the Fed will have to be. This is the textbook recipe for how a central bank should behave.
High inflation is a problem for several reasons. Today, many people are experiencing a severe erosion of their standard of living, as increases in the prices of the items they buy outpace the increases in income they can receive. High inflation also makes it difficult to make decisions about major day-to-day issues, such as how much to save for retirement. And it increases anxiety, in part, because high inflation also tends to be more volatile and unpredictable.
Unfortunately, the only remedy for persistently high inflation is recession. So the current difficulty in rising prices is likely to increase unemployment over the next year or two. The Fed understands the costs many Americans will likely have to bear in order to lower inflation, but there is no other way. The worse the inflation problem, the greater the cost of the recession.
In 2021, when inflation was emerging as the first problem, it concentrated on categories directly affected by the pandemic. Cars, for example, saw their prices rise due to a Covid-related microchip shortage.
Now, prices are rising for many household purchases, including daily necessities. In the 12 months ending in September, the consumer price index increased by 8.2%. Food prices rose by 11.2%, energy prices by 19.8% and shelter costs by 6.6%. Together, these components make up a little more than half of the average market basket. These are items that consumers cannot do without, so they have less discretion whether to spend or not.
The question now is how much more the Fed will have to do to get inflation back to its 2% target level. It has already raised interest rates three times this year by a quarter of a percentage point, leaving widespread speculation that more rate hikes are to come. It has also begun to shrink its balance sheet by unwinding some of its bond purchases – another method of rolling back the financial support provided during the Covid era.
No one knows whether these actions will be too little, too much or just right. That will depend on dozens of factors beyond the Fed’s control, including how Russian President Vladimir Putin’s ongoing invasion of Ukraine will affect world energy and food supplies; how virulent are the next strains of Covid and how deep is China’s economic decoupling from the world.
Despite the uncertainty, we know two things for sure. First, the Fed will need to constantly be in course-correcting mode, adjusting its policies in response to unexpected developments to help get the economy back on track. Lately, the inflation news has been worse than expected, so the Fed has wisely responded by being absolutely clear that it will raise rates as much as necessary to quell inflation, even at the cost of sending the US economy into recession. If we get news in the other direction, the Fed may pull back.
Second, this is a battle the Fed must win. We learned in the 1970s what happens when central banks fail to meet their responsibilities to fight inflation: we end up with an inflationary avalanche that is increasingly difficult to stop.
Dealing with the inflation problem now will be painful as it will likely cost many workers their jobs. But not addressing it now would only make things worse, as households and businesses become more convinced that high inflation is here to stay and becomes a self-fulfilling prophecy. Faced with this possibility – painful now, or more painful later – the Fed is taking the right path.
The process of lowering inflation will be too slow to anyone’s satisfaction, as it involves setting off a chain reaction that often takes a year or two. The first step is that financial conditions must be tightened; this step is already in progress. Lending rates have risen sharply, stock prices have fallen, and the dollar has strengthened in foreign exchange markets.
Subsequently, tighter financial conditions must limit demand. Higher loan rates make borrowing more expensive when buying new homes, cars, and business capital. Lower stock prices mean that families lucky enough to own stocks are suddenly less wealthy, so they cut back on spending. A stronger dollar makes U.S.-produced goods and services relatively expensive compared to items produced overseas, another necessary element of cooling demand. This second step is still a long way off. Housing construction has slowed, but the job market remains seriously overheated, with far too many unfilled jobs compared to the number of available workers.
Finally, softer demand will eventually encourage companies to reduce price increases, and workers to temper wage demands. Once there is convincing evidence that this last step is underway, the Fed will be able to start cutting rates. As this happens, employment gains will recover, the unemployment rate will decline, and inflation will once again be low and stable at around 2%. Economic life will – eventually – return to something like “normal”.
The next year or two will certainly be tough. But the only thing worse than dealing with today’s inflation would be not doing it. The economy will not function to anyone’s satisfaction until inflation is controlled. There is no alternative but to grit your teeth and get on with it.