I have had a number of questions recently about inflation and what that means for the Fed and interest rates. The general assumption seems to be that inflation is about to rise sharply and that the Fed will be forced to raise rates to control it, with the usual panoply of devastating side effects. The taper tantrum gets mentioned frequently, as when rates rose sharply and derailed stock markets after the Fed suggested it would tighten policy.
This discussion always gets more intense when the Fed meets (like now) and speculation rises about what it will announce. According to much of the narrative, the Fed will have to choose between keeping inflation under control and tanking the stock market. As the old saying goes, we have two paths in front of us: one leading to destruction and the other to utter despair. We must hope the Fed chooses wisely.
Personally, I don’t expect the Fed to announce anything different in this meeting—nor should it. The way I look at it, the Fed is operating just as it should, by balancing competing objectives in the real economy and choosing the options that create the least damage. The general narrative, on the other hand, is largely focused on the financial economy, and that disconnect is the cause of much of the angst. All of the choices have problems, yes. But if we look at the real economy? It is clear that the problems are not all equivalent.
A Matter of Priorities
For the past several decades, the Fed has been largely focused on the financial economy—and rightly so, as that is where most of the problems arose: inflation in the 1980s and financial excess and crises in the 1990s and 2000s. The real economy was, on the whole, not generating major problems that monetary policy could address. The Fed’s dual mandate of price stability and full employment was focused on the first because the second was much less problematic.
Now, of course, we have millions of people out of work, and inflation is still quite low by historical standards. The Fed is looking at the second part of the mandate because that is what is most urgent and most important. Chair Powell and others have been quite clear this will continue to be the case as long as needed. Raising rates due to inflation is a nonstarter until employment recovers.
Economy Starting to Normalize
That doesn’t mean inflation will stay at all-time lows, of course. In a normal economy, circa 2017–2019, we saw headline inflation running between 1.5 percent and 3 percent. In the past couple of months, we have seen inflation run from about 1.5 percent to 2.5 percent. Again, this is from the lower end of the historical normal to within that range and with some headroom for further growth, which is likely in the short term. When we look at the core inflation numbers, we see exactly the same thing. In other words, inflation is normalizing, which is what we should expect as the economy normalizes.
That pattern is also consistent with what we see for interest rates. As the economy normalizes and gets back to conditions like, say, 2019, we should expect rates to rise to the levels we saw then. In fact, that is exactly what we have seen so far. We still have some room to go, which suggests rates can and should rise further as things get more normal, but that does not mean rates are now on an unstoppable path up. So, from a Fed perspective, both inflation and rates are roughly where they should be and are therefore not a risk. Nothing to see here folks, and no need for the Fed to act in accordance with its mandate.
Jobs, on the other hand, are still well underwater despite the normalization. Job growth has been strengthening significantly this year, but it remains more than 8 million below the prior peak. Employment is well below the full level. Even given current strong growth, we might be a year (or more) away from that level. This is the mandate the Fed is focusing on, as it should, and it calls for continued easy policy and no significant changes.
A Focus on Employment
The economy is normalizing and so are inflation and interest rates. The jobs market is still a long way from normal. The Fed has said very clearly it is focused on employment, not inflation. Believe the Fed because it is doing what it should. Look for the announcement to say pretty much just that.