The Fed attacks inflation, with risks in tow

In the 1970s, we suffered through “stagflation” — a stagnant economy and high inflation. Now, for a few months at least, we experienced “boomflation” — a booming economy and high inflation.

Consider: Household savings are up. The median balance of household checking accounts was more than 50% higher in July than the same period in 2019. Workers are enjoying some of their best raises in decades. Job openings are at an all-time high, leaving many people feeling confident enough to quit their jobs and look for better work.

In November, President Joe Biden signed a bipartisan $1 trillion infrastructure plan into law, sending money into improving transportation, the utility grid and broadband.

Yet at the same time, inflation rose again in November, with the Consumer Price Index hitting the highest level since 1982. That was when then-Federal Reserve Chair Paul Volcker brought on a severe recession to snap the U.S. economy out of runaway inflation.

In 1982, we were on the downslope of years of rising prices. Now we may be on an upslope, but I doubt if it’s for long. The increase in November was smaller than October.

More important, the Fed is winding down its stimulus program of bond buying and preparing for at least three interest-rate increases next year.

Politically, inflation will hurt the Democrats more than any domestic accomplishments (indeed, Republicans can argue they overstimulated the economy, goosing the increase in prices) and bring promises to cut spending, taxes and regulation (not that any of this would address inflation).

Not everyone has adult memories of the high inflation of the 1970s. According to the Census Bureau, the median age of Americans is 38 years.

But voters feel pain at the pump — rising gasoline costs have been among the biggest problems — immediately, viscerally, every time they fill up. It makes one wonder how the government can ever combat climate change by needed higher fuel prices. Also, higher wages are eaten up by inflation.

No wonder the latest (October) University of Michigan Survey of Consumer Sentiment fell to its lowest level since the pandemic recovery. The economy may be booming but consumers feel lousy.

Still, the Federal Reserve’s interest-rate hikes are when things get tricky.

The pandemic has skewed the economy, including disrupting supply chains — this has been felt in semiconductors needed for auto manufacturing, raising vehicle prices. High housing prices are another driver of inflation. COVID-19 has also changed consumer behavior. 

Josh Hausman, economics professor at the University of Michigan, wrote in The Atlantic: “But remember that inflation rates tend to rise, quite simply, when households want more goods and services than firms can easily supply. And note that both fear and COVID-related restrictions have shifted demand from services to goods.”

He continued, “Some people still fear seeing a movie in a theater; others may dislike wearing a mask while seeing a movie. Both factors push consumers to buy home-entertainment equipment. Fear of public transportation increases demand for cars and bikes, and fear of eating in restaurants increases demand for kitchen renovations and equipment.”

In other words, the central bank has limited control over rising prices.

On the other hand, Fed overreaching on interest rates would certainly choke inflation but at the risk of sending the economy into a recession. Many post-World War II downturns can be blamed on the central bank tightening credit too much, too fast.

This begins to hammer the second of the Fed’s “dual mandates”: price stability and maximum sustainable employment. Despite the good signs in the labor market, the nation is still 6 million jobs short of where it would have been without COVID. A recession would make this situation substantially worse.

Another risk is the omicron variant of the coronavirus, which may grow worse in January. Modeling by the Centers for Disease Control and Prevention laid out a “triple whammy” worst-case scenario, with this variant atop delta and influenza. It could overwhelm hospitals, particularly in states with low vaccination rates.

If this led to another shutdown, then the Fed may have to back off its plans to raise rates and inflation would persist.

Mary Daly, president of the San Francisco Fed, said in a speech this past month, “We have the tools to support the economy if it needs it, and we have the tools to beat back inflation and cool the labor market if necessary. The question is, which of these scenarios will turn out to be true?”

But she admitted that, “Monetary policy is a blunt tool that acts with a considerable lag.”

In other words, raising rates wouldn’t do much to quickly improve production, switch consumer spending from goods to services, and mend supply chains.

“But it would curb demand 12 to 18 months from now,” she said. “Should current high inflation readings and worker shortages turn out to be COVID-related and transitory, higher interest rates would bridle growth, slow recovery in the labor market and unnecessarily sideline millions of workers.”

One thing is sure: More vaccinations are as important to returning the economy to normal as any monetary policy.