Opinion | Inflation Could Stay High Next Year, and That’s OK

In life, description should precede prescription. You observe reality (description) and then decide what to do (prescription). Too often, though, people work backward. They start with a judgment and then assemble a version of reality that supports it. To wit, face masks are bad, therefore face masks don’t protect against the coronavirus.

Adam Posen thinks some of his fellow economists who share his belief that interest rates should remain low may be guilty of this mental error. Influenced by their own views on monetary policy, he says, they are unrealistically optimistic that today’s high inflation will go away quickly. “Wanting to be right in one’s policy proclivities and pronouncements seems to be driving most forecasters’ views,” Posen, who is president of the Peterson Institute for International Economics, wrote me in an email this week.

Members of the Federal Open Market Committee, which steers interest rates, have been more or less unanimous that today’s high inflation is purely transient. In June, the median of their projections for the Fed’s favored inflation measure in 2022 was just 2.1 percent. That’s pretty low considering that the price measure the Fed tracks rose 4 percent in the 12 months through this June.

Posen expects inflation to be above 3 percent next year — nevertheless, he thinks that the Fed should keep short-term rates near zero. That’s because he thinks the burst of inflation will recede after 2022. And he doesn’t think another year of 3-plus percent inflation would be enough to embed expectations of high inflation in the minds of consumers and businesses.

What’s the harm if policymakers are allowing their prescriptions to guide their descriptions? Posen, who was a monetary policymaker for the Bank of England from 2009 to 2012, sees two problems. One is that if inflation comes in above their forecasts, as he expects, their credibility will be damaged, opening the door to more hawkish policy. “It will increase external pressure on F.O.M.C. to tighten prematurely,” Posen writes.

Second, Posen thinks the Fed risks muddying its message to the markets by trying to have it both ways on inflation. On one hand, the Fed committed last year to deliberately letting inflation drift above 2 percent occasionally to make up for periods when it has been persistently below its 2 percent target. On the other hand, it’s portraying today’s elevated inflation as anything but deliberate — a Covid-related spike that won’t last. The more that Fed policymakers insist that they expect inflation to drop sharply next year, the more they undermine their message that they are comfortable with letting inflation overshoot to offset past undershoots. And if inflation does stay high next year, contrary to their stated expectations, it will look like a bungle on their part rather than part of a deliberate strategy.

This is coming up now because the chair of the Federal Reserve, Jerome Powell, is slated to give a speech on the U.S. economic outlook on Friday as part of the annual Jackson Hole Economic Policy Symposium, a conclave of central bankers that is being conducted virtually for the second year because of the pandemic.

Powell and his fellow policymakers are under pressure from inflation hawks to cut back purchases of long-term bonds and to raise short-term interest rates soon to quell inflation.

This first chart bolsters Posen’s argument that expectations for long-term inflation are hard to budge. It shows expected inflation for the five-year period starting in five years. For example, the figures for January 2017 represent what the financial markets were projecting at the time average inflation would be from January 2022 through January 2027. It’s based on the differences in yields between ordinary and inflation-protected Treasury securities.

The second chart shows that despite the reassuring outlook for inflation, investors are expecting the Fed to raise rates next year — earlier than the Fed itself predicts it will act. In June the “dot plot” of F.O.M.C. members’ predictions showed that the median member saw the federal funds rate remaining at 0 to 0.25 percent through the end of 2022. But this chart shows that traders in the Fed funds futures market put only about a one-third probability on rates staying that low.

So, maybe investors are thinking that the Fed will raise rates in 2022 unnecessarily even though long-term inflation expectations are mild. Or maybe they’re thinking that inflation will remain under control precisely because the Fed will act to cool it off next year. The market is not easy to interpret.

And of course the market may be wrong. Posen thinks that if anything, the Fed will hike sooner than the markets are expecting because inflation will be higher than the Fed expects. And he thinks this would be a mistake. Of Fed policymakers, he writes, “The Fed should keep its nerve for longer, and hold off raising rates even if inflation comes in well-above target for 2022 as I forecast.” And, “There is a risk that inflation could accelerate by waiting, but it is small, and the benefits of truly delivering on full employment outweigh the risks.”

Elsewhere

“We have to prove democracy still works — that our government still works and we can deliver for our people,” President Biden told Congress in April. Biden’s bottom line was correct, concludes a new National Bureau of Economic Research working paper based on an analysis of more than 110 countries. “Democracies breed their own support only when they are successful: all of the effects we estimate work through exposure to democracies that are successful in providing economic growth, peace and political stability, and public goods,” write Daron Acemoglu of the Massachusetts Institute of Technology and four other authors.

Quote of the Day

“In a pilot program we ran in Kenya a few years ago, around 5,000 sixth-grade girls in 163 primary schools were given a $6 school uniform free. If they stayed in school, they received a second uniform after 18 months. The dropout rate over the next three years decreased by a third, to 12 percent, and the pregnancy rate fell to 8 percent from 12 percent.

Esther Duflo, “An Education,” The New York Times (2009)

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