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Three Questions

Controlling the Virus Is the Key to Reducing Inflation

Demand is surging, supply chains are a mess, and prices are high. Last week, the Commerce Department put hard numbers behind consumers’ distress: inflation has been rising at its fastest pace since the early 1990s. Yale SOM’s William English, a former economist at the Federal Reserve, explains the role of COVID-19 in the spike, considers how policymakers can respond, and confronts the sheer uncertainty of the times.

Groceries at the register at a supermarket
Photo: David Paul Morris/Bloomberg via Getty Images

Is the jump in inflation in October worrisome for the long term?

The current inflation situation is complicated, and one month’s data isn’t enough to change that story much. Partly, the higher inflation since the spring reflects the very strong rebound from the pandemic in the U.S. and elsewhere, driven in part by robust monetary and fiscal policy responses. That rebound has pushed up demand faster than producers expected, and it is taking time for producers to catch up.

And partly, it reflects a sharp shift of demand from services (which are more exposed to COVID risk) toward goods (partly as substitutes—people buying cars rather than riding mass transportation, for example). That shift has meant that demand for goods has been extraordinarily high, boosting prices further. A final cause is the dislocations to supply chains caused by the pandemic, which have made it even harder for producers to keep up with surging demand.

All of those forces will subside as COVID fades, but the risk is that the high level of inflation in the meanwhile will get built into price-setting and wage-setting behavior, and thus lead to a more persistent rise in inflation. That is possible, and the recent increases in prices outside the obviously affected sectors, as well as in wages, suggest it’s a real risk for the Fed. Of course, as the outlook for inflation has changed, the Fed has made adjustments to the actual and anticipated path for monetary policy, but there may well be more adjustments to come.

In 2020, the Fed announced that it would prioritize employment by letting inflation rise above the target rate. Are the assumptions underlying that policy change still valid?

The Fed’s new framework was aimed at concerns that arose in the aftermath of the 2007–09 financial crisis. Specifically, the federal funds rate, the Fed’s usual monetary policy tool, reached essentially zero while the economy remained weak. Since the Fed couldn’t provide much additional accommodation with its usual tool, it turned to unconventional tools. Nonetheless, the economy was persistently weak, with inflation below the Fed’s target for several years. Subsequently, the Fed judged that the economy was nearing its “maximum employment” objective and tightened policy starting in 2015, but it turned out that the economy had more room to grow than the Fed had believed. So, ex post, the Fed thought it had raised rates earlier than it needed to.

To address these concerns, the Fed adopted a new approach, under which it would keep monetary policy easy until it could see that full employment had been achieved—because wages began to move higher—and inflation had returned to its target level of 2%. Then it would tighten policy, but it would allow inflation to overshoot its target for a time. That overshoot would mean that inflation would average near target, because the overshoot would offset the period of low inflation during the recession.

That change in approach made sense, but the situation we face now is very different than the one following the financial crisis. Because of the effects of the pandemic and the policy response, inflation has been high, not low. So the Fed may have to tighten monetary policy before it is confident that it has reached full employment in order to avoid having the higher inflation get built into price-setting and wage-setting behavior and become a persistent problem. Indeed, the Fed has already communicated that it will take such action if it becomes appropriate.

Thus, the Fed’s new framework is likely to be much less helpful for guiding monetary policy over coming quarters than had been hoped. However, it may still be a useful framework over time, since the economy may well end up operating with low inflation and low interest rates again. The underlying factors that led to the sluggish economy in the decade before the pandemic (among them, an aging population, high global savings, and slower productivity growth) are still there, after all.

Are rate changes from the Fed or policy changes from the White House and Congress needed to get the current wave of inflation under control?

“Putting the pandemic behind us would allow more of the economy to reopen and encourage a shift of demand from goods back to services. Those changes would allow producers to catch up with demand and take some of the pressure off prices.”

The main thing that we need to help bring down the current high inflation is an improvement in virus numbers that truly puts the pandemic behind us. That would allow more of the economy to reopen and encourage a shift of demand from goods back to services. Those changes would allow producers to catch up with demand and take some of the pressure off prices. It would also give workers more comfort that they can go back to work safely, easing pressures in labor markets and reducing increases in labor costs that can contribute to inflation.

Fiscal policy should also help ease inflation pressures. The Brookings Institution estimates that fiscal policy contributed about five and a half percentage points to growth over the four quarters ending in the first quarter of this year. But by spring 2022, that contribution is estimated to be negative negative two and a half percentage points. That’s a swing of minus eight percentage points on the growth rate of the U.S. economy! So we should expect to see a significant slowing in growth this winter and spring, and that should help with inflation. However, the timing and extent of that slowing is very uncertain. We simply have no history to use to judge with precision the likely effects of the extraordinary fiscal policy actions taken over the last two years.

The Fed has the hard job of calibrating monetary policy in a way that balances the risks to the outlook in a very uncertain environment. On one side are risks of more persistent high inflation, and on the other side are risks of a sharp slowdown that leaves the recovery from the pandemic incomplete.

That balancing act requires that policymakers keep their options open. Going forward, the Fed will need to say—and mean—that its policy is not on a preset course, and it will have to monitor developments closely and respond accordingly. That could mean a relatively swift reduction in asset purchases and a move to higher rates. But it could also mean a more gradual and perhaps uneven reduction in purchases and a long period with no change in rates. I’m afraid it is just difficult to be confident at this point how the transition to policy normalization in the U.S. will play out.

Department: Three Questions