Was the Fed right to focus so much on inflation?

• Steven Russell is Professor of Economics at Indiana Purdue University Indianapolis.
• Joydeep Bhattacharya is Professor of Economics at Iowa State University.

Over the past year, the Federal Reserve has faced a serious problem. Should it tighten monetary policy to try to lower inflation? Or should it ease off to support economic growth – or at least prevent a looming recession – but perhaps allow prices to continue to rise? That’s a problem because the tools the Fed uses to try to lower inflation also slow the pace of economic activity.

Which path has the Fed taken? Although it eased monetary policy drastically during and immediately after the pandemic, it changed course drastically from early 2022. Since then, it has pushed up market interest rates no less than 10 times, raising two rates that it directly or indirectly controls: the IORB rate, which is the rate it pays banks on their reserves, and the Fed- Funds rate, which is the rate that banks charge other banks that borrow reserves from them.

Obviously, the Fed was troubled by unusually high inflation rates that started in early 2021, were near double digits last summer and aren’t over yet. Has it done the right thing by focusing almost exclusively on inflation and looking away from the real economy?

Inflation can be tough for people on low incomes. Part of the reason for this is that the prices of all goods and services are not rising equally: the prices of basic commodities that people on low incomes buy more of (gas, groceries, rent) tend to rise faster than the prices of commodities the items most consumed by the wealthy (golf clubs, wine). But recessions hit hard, people who lose jobs or hours as a result, and young people who enter the labor market but cannot find work. These people are disproportionately poor. In addition, there are many jobs that disappear during a recession and never come back afterwards.

In a country like the United States, which has a limited, ragged economic safety net, the impact of a recession on low-income people is particularly bad. With Republicans in control of the House of Representatives but a Democratic president, efforts to expand that safety net in the event of a recession will likely be very limited, if they take place at all.

Our reluctance to advocate further Fed tightening – which may have already gone far too far – is influenced by our view of why inflation is happening. We did not have high inflation after the great recession of 2008-2009, although the Fed initially reacted similarly aggressively to monetary policy. But we had a very long period of high unemployment. Although the Great Recession officially ended in the summer of 2009; The unemployment rate, which peaked at 10% a few months later, did not drop to 5% for almost six years after that!

In contrast, the short but severe pandemic recession officially ended in spring 2020 when the unemployment rate hit nearly 15%. However, less than a year and a half later, in early autumn 2021, the rate was below 5% again. Millions of people returned to work or found a first job much faster than after the Great Recession and under enormous strain was avoided.

Fed policy wasn’t the only reason the unemployment rate fell again so quickly. The particular cause of the recession and a very aggressive fiscal policy response played a role in this. But whatever the reasons, all of those unemployed got their jobs and spending power back fairly quickly while the manufacturing side of the economy was still recovering from disruptions from the pandemic, including supply chain disruptions. They wanted their share of the goods and services that the economy was struggling to produce and deliver. To get that share, they had to sort of get the rest of us, who were much less affected by the recession, out of the way. This happened through price increases, which reduced our purchasing power.

If we’re right about the cause of inflation, it may have abated spontaneously without requiring any action from the Fed. As former Fed Vice Chairman Alan Blinder wrote in his June 2022 Wall Street Journal article, “Depending on the specifics of timing, inflation will fall just as quickly and dramatically as it has risen.” We’ve had it before We didn’t need the Fed to tighten to achieve sustained low inflation after the Great Recession, and we probably don’t need it to avoid a really long period of high inflation either. But the Fed felt it had to step in to maintain its anti-inflation reputation. It will acknowledge that inflation may have eased anyway and seek to avoid blaming a recession that almost certainly would not have happened anyway.

Steven Russell is Professor of Economics at Indiana Purdue University Indianapolis. Joydeep Bhattacharya is Professor of Economics at Iowa State University.