Under Volcker, the Fed has finally dropped its proverbial stance.Soaring interest rates; businesses that rely on debt financing – including construction and car sales – struggling; and Unemployment hits 10.8%, a level that would not have reappeared before the global financial crisis. But it worked: Inflation fell from 13.5 percent in 1980 to 3.2 percent in 1983.
The story is usually told triumphantly – brave Volker, taking the painful but necessary steps! However, now that our own Fed chair may face the same ugly trade-offs, I admit that I am thinking more about the deep pain caused by the recession. Of course, losing 8% of purchasing power to inflation is bad. But even worse, 100% of that was lost to unemployment—and the collective pain of the unemployed is arguably far greater than that of inflation-stressed households.
so i ask John WhitingaThe man who taught me macroeconomics at the University of Chicago Booth School of Business 20 years ago: Why is recession better than high inflation? In short, his answer was: no. “If it were me, and I was in charge of monetary policy, would I trigger a Great Recession to keep inflation low? No. But I would try to get to a stable inflation rate and then gradually reduce it over time.”
To understand his motivation, suppose you know that inflation is exactly 10% per year. It’s a very high rate of inflation, but if everyone knew what to expect, we would figure out ways to mitigate that. Interest rates on bonds and savings accounts will rise to offset inflation losses. The employment contract will provide for a 10% annual increase in living expenses. Similar adjustments will be built into Social Security checks and pensions.
Now compare that to the unexpected 10%, which is pretty close to what we’re experiencing right now. Suddenly, everyone’s grocery budget ballooned, savings lost a significant portion of their value, and people worried about being able to refuel their cars. This is a completely different and worse phenomenon because it keeps us from planning our financial lives.
“We haven’t reached a new equilibrium where the level of inflation is expected,” Huizinga said. “It’s the worst kind of inflation because it means we’re making bad decisions every day.” If we knew, we’d take mitigation. Instead, we were slammed for costs we didn’t plan for.
Now, obviously, it would be better to have no inflation at all because these adjustments are imperfect. People who put their life savings into a fixed annuity before inflation wiped 8% off their value will now be in a permanent situation worsening. Also, adjustment mechanisms that help people offset the costs of inflation could make it harder for the Fed to control inflation. If businesses expect costs to rise 5% next year, they will demand higher prices to offset the increase, and if workers expect higher prices, they will demand higher wages, which will translate into higher business costs. When expectations are “disconnected” from monetary policy in this way, inflation can take its course.
But without a time machine, it would be too late without inflation. So what to do now?
I agree with my old professor that the best thing the Fed could possibly do is stabilize inflation and then gradually lower it. I’m just wondering if this is possible.On the one hand, it may be too late to avoid a recession; we already have Negative growth in the first quarter. But the bigger uncertainty is whether the Fed can announce a high and stable inflation policy and stick to it.
Decades of reliable maintenance 2% inflation target, will the Fed suddenly announce that it will keep inflation high – but not higher? Or will expectations of future inflation spiral out of control and fly into the stratosphere? Is it politically possible for the Fed to stick to this course and anxious Americans to ask Congress to do something (like appoint an inflation hawk to the board)? Given the political constraints, the Volcker approach remains our best bet, despite all the costs — nonetheless, the Fed has all the more reason to ensure that inflation not only falls, but stays low.
“If you let inflation start again, who knows how quickly people will start anticipating that?” Wiisinga said. No matter what you do, “breaking the cycle is very expensive.”