Opinion: The toughest part of the Fed’s job may already be done

Opinion by David Wilcox for CNN Business Perspectives

The US economy may have begun to cool some, but it is still seriously overheated. Employers are desperate to hire workers, but they are nowhere to be found. Customers are eager to purchase new cars, but dealer lots are almost bare. Would-be vacationers are anxious to make up for lost time, but airlines can’t handle the volume.

As a result of that overheating, inflation has surged. In May, the Personal Consumption Expenditures price index, the measure the Federal Reserve pays closest attention to, increased by 6.3%. Now, the question is how hard it will be for the Fed to bring inflation back down to its 2% goal — and how deep a recession may be required to get the job done.

The answer largely relies on the mindset of American households and businesses, as inflation is — to an important degree — a self-fulfilling prophesy. If consumers believe inflation will ease, they’ll be less militant about demanding large pay increases, for instance, and employers will be more resistant to granting them. If expectations are well anchored, too-high inflation will substantially take care of itself once the economy is no longer overheated. So if households and businesses maintain the view that inflation will return to 2% in the not-too-distant future, the Fed’s task in accomplishing that outcome will be much easier. In fact, it may have already set expectations in financial markets that are roughly tough-enough in terms of how much it will raise interest rates in the future.

However, a more pessimistic outcome is also possible: The experience of escalating prices at the gas pump and grocery store over the past year may have conditioned households and businesses to expect more of the same. In that case, the Fed will need to raise its policy interest rate much higher — and the economic slump ahead will be much deeper.

But there are reasons to be optimistic. In the University of Michigan’s monthly survey of households, respondents continue to expect much higher inflation over the next 12 months than they anticipated pre-covid. But their longer-term expectations have shifted remarkably little, and are not much higher today than they were a decade ago.

Another gauge of inflation expectations can be teased out by comparing prices on conventional Treasury securities vs. ones that are protected against inflation. Like the respondents to the Michigan survey, Treasury market investors see inflation over the next five to 10 years coming back into line with the Fed’s 2% target.

Even if these longer-term inflation expectations remain well-anchored, the Fed will still have to go ahead with the widely expected hike of three-quarters of a percentage point on Wednesday. And it still will have to follow through with the additional rate increases that financial markets currently anticipate. But so long as consumers continue to believe that inflation will moderate over the longer term, it shouldn’t have to raise rates much — if at all — beyond that.

The road ahead is full of uncertainty and likely to be bumpy. Nobody knows what Putin’s next moves will be in Ukraine, or what curveballs the coronavirus may have in store for us, or what new snarls may develop in the globe’s tangled supply chains. All of those factors and more will play a role in determining the future course of inflation.

On top of all that, no one knows how much the labor market will cool. The Fed’s policy-setting committee expects the unemployment rate to increase about half a percentage point over the next couple of years, consistent with demand and supply in this market coming back into line. But once that softening dynamic is put in motion, accidents can happen; what starts as a mild softening can easily morph into a more serious downturn.

Even if a recession ensues, it will be mild compared to what happened four decades ago. In 1979, Paul Volcker took office as Fed chair amid an even worse outbreak of inflation than we’re experiencing now. The public had been conditioned by the experience of the prior 15 years to expect inflation to be high and rising. Partly because of that conditioning, the cost of conquering inflation was tremendous. Volcker and his colleagues had to let the Fed’s policy rate go above 20% and tolerate an unemployment rate exceeding 10%.

Progress against today’s high inflation won’t come as quickly as anyone wants. But a year from now, inflation will have come down substantially from its current level, and by two to three years from now, it should be in the neighborhood of 2%. Everyone will be a little less angry.

In the meantime, if you listen to Fed Chair Jerome Powell carefully, you’ll hear him invoke one name surprisingly frequently — Volcker, the patron saint of inflation control. There’s a reason why he’s doing that: If he can persuade the American people that he’s serious about controlling inflation, his job will be a whole lot easier.

In fact, his work may be mostly done already.

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