The Fed Can’t Reduce Inflation by Winging It

The central bank needs a systematic strategy, such as the Taylor rule, and a focus on real interest rates

By Andrew T. Levin and Mickey D. Levy. Mr. Levin is a professor of economics at Dartmouth College. Mr. Levy is a senior economist at Berenberg Capital Markets. Excerpts: 

"The economy now faces a serious risk of persistent high inflation. To avert such disaster, the Fed needs a systematic strategy—including contingency plans—and it needs to explain to everyone what that strategy is.

Since inflation began to accelerate in early 2021, Fed officials have been overly optimistic that it would quickly recede to the central bank’s 2% target. In clinging to that rosy outlook, the Fed completely misjudged how the government’s unprecedented fiscal stimulus—along with its own extraordinary monetary accommodation—would affect aggregate demand and inflation. In its most recent June economic forecast, the Fed projected that raising interest rates a few more notches would be enough to reduce inflation, while incurring only a minor effect on the unemployment rate. Such a benign outcome remains plausible, but it would be a grave error for the Fed to ignore the possibility that inflation could turn out to be much higher."

"The price of shelter, the single biggest component of consumer inflation, rose 6.2% over the past year and accelerated to an annualized rate of 7.6% over the past four months. It typically takes a year or more for changes in home prices to be reflected in rental costs and owner-occupied rental equivalents."

"Healthy gains in employment and disposable personal income are fueling nominal consumer spending growth, and confidence has lifted. These trends reinforce the view that monetary policy isn’t exerting any substantial disinflationary pressure.

A crucial pitfall in the Fed’s approach has been its focus on nominal interest rates rather than the inflation-adjusted interest rate, the traditional barometer for assessing the success of the Fed’s monetary policy. This week the Fed is expected to raise the federal-funds rate by 75 basis points to 3.25%. The real interest rate, however, will remain deeply negative, rendering the Fed’s monetary stance inconsistent with its inflation target."

"But a fed-funds rate of 4.25% will prove severely inadequate if core inflation keeps running well above 4%. In that case, holding the policy rate at 4% would still entail a negative real interest rate and continuing monetary stimulus that would generate further upward pressure on nominal spending."

"Chairmen Paul Volcker and Alan Greenspan both emphasized that price stability is the best foundation for sustained economic growth, and both raised real interest rates sharply to combat inflation."