The battle against inflation during the Biden years is almost behind us. But we’re in danger of learning the wrong lessons from it.
The Federal Reserve, holding its last meeting of the year this coming week, has been fighting runaway consumer prices for nearly three years. So far, at least, it has managed an unusual feat: The rate of inflation has dropped sharply from its peak and there has been no recession.
Yet the Fed is stuck in a difficult place. With prices still rising faster than the central bank’s 2 percent target, the incoming Trump administration will be hypersensitive about inflation, which was a decisive factor in the November elections. At the same time, the new administration’s policies on tariffs and immigration could set off another inflation surge. So the Fed must remain acutely vigilant on the inflation front.
But it will have to keep experimenting, to be ready for the curve balls coming from future recessions. Some economists believe the Fed would gain flexibility if it reconsidered its 2 percent inflation target, though they say the central bank can’t take that step now because it is under too much pressure to preserve its own institutional independence.
Still, a single-minded focus on inflation could leave the Fed without the right tools for coping with economic downturns ahead.
The Fed’s predicament reminds me of a general who is endlessly fighting the last war — conscientiously dissecting the tactics of recent battles and failing to prepare properly for the next ones.
An Accident of History
The latest government figures show that the Consumer Price Index in November rose at a 2.7 percent annual rate. That’s still higher than the Fed is aiming for, but it’s a tremendous improvement from the peak of more than 9 percent in 2022. The overwhelming consensus in the markets is that Fed policymakers will cut rates this coming week by a quarter point, to a range of 4.25 to 4.5 percent.
But because the Fed’s longtime target is a 2 percent inflation rate, the markets assume that the Fed will probably pause its rate cuts in January and remain on high alert for another inflation surge.
It has little choice. The Fed has a dual mandate of keeping inflation low while maximizing employment, and it has only one main tool for achieving it: interest rates, which it can move up or down. This forces the Fed to make difficult decisions about which of its two goals it is going to emphasize at any given time.
It can be hard to experiment in the middle of a crisis, though the Fed has done it repeatedly in the last 20 years. Before the recent battles with soaring prices, both the Fed and the Biden administration had begun experiments aimed at ensuring that economic growth was robust and equitably distributed. Inflation-adjusted income levels are difficult to disentangle, but it’s clear that during President Biden’s term, wages for people in the lowest income groups rose.
Even earlier, in August 2020, the Fed made a significant, though subtle, adjustment to its approach to monetary policy. It changed its 2 percent inflation target from a hard ceiling to a “symmetrical” goal — meaning that inflation is as much a concern when it is too low as when it is too high. And because the annual rate of inflation had been below 2 percent in most years from 2008 through 2020, it implied to many economists that inflation could rise above 2 percent for an extended period without causing undue worry.
That change in Fed doctrine was an important start, but it hasn’t had much effect in practice. Inflation since 2021 has been so high that the Fed hasn’t been able to ignore it. That’s too bad, because the 2 percent inflation target is anachronistic. It is an accident of history, an arbitrary number that New Zealand central bankers settled on more than 30 years ago. The target gradually caught on among the world’s central banks and has by now been given an artificial significance without scientific backing, as I explained in March.
But the 2 percent target isn’t just a historical oddity. It may be warping monetary policy, causing the Fed to maintain a single-minded focus on inflation even when it doesn’t really have to. This, some economists say, will lead over the long run to more frequent recessions, potentially throwing millions of people out of work.
Open-minded experiments in monetary and fiscal policy could potentially bring a greater degree of income equality to this stratified country. The Fed always needs to continue looking beyond the horizon, even as it puts out inflation brush fires.
Covid Inflation
Four years ago, the United States faced very different economic problems. Back then, the Covid-19 pandemic plunged the world into a deep recession — one that, in the United States, was mercifully brief.
A combination of vast fiscal and monetary stimulus helped the economy recover quickly. In retrospect, it appears that the huge quantity of money that was poured into the economy, combined with the pandemic itself, contributed to imbalances in supply and demand that set off a sharp rise in global price levels.
There were shortages of toilet paper, masks, computer chips and cars. Companies increased prices. Restaurants and delivery services couldn’t hire enough workers. The United States endured the worst inflation since the 1970s and 1980s.
With hindsight, I think it’s also clear that the Fed wasn’t prepared for it. Previous decades of disinflation, low growth and ultralow interest rates left it flat-footed when it needed to be nimble. It wasn’t attuned to the danger of the new, red-hot inflation that unsettled consumers — and, eventually, voters.
Half Lives
At least we’re past all that now. Since the summer, inflation has been subdued, in the 3 percent range, an annual rate that, I think, most people can live with. But memories of runaway inflation still linger, consumer sentiment surveys show.
Neale Mahoney, a Stanford economist, has done research on this. He told me that inflation has a “half life” of one year. “If you calculate the total experience, the total impact of inflation, 50 percent gets felt in the first year,” he said. “Another 25 percent gets felt in the second year and another 12 percent the next year.” That means “most of the impact of inflation has occurred within three years.”
His research implies that by next year — three years after the 2022 peak — the inflation shock will have worn off. From the standpoint of the public opinion, the Trump administration and the Federal Reserve will have a fresh start in 2025.
Mr. Mahoney worked as an economic adviser in the Biden administration from June 2022 to June 2023. The timing of the inflation battle was unfortunate for Democrats. That timing, he said, “is something that I’ll be thinking about for a long time.”
If the timing were a bit different, this might be a better moment for the Fed to examine whether 2 percent is really the inflation target the United States needs.
Laurence Ball, a Johns Hopkins economist, told me that while he doesn’t think the Fed is in a position to alter that target now, he continues to be convinced that eventually it should. With a higher target, inflation could settle around 3 percent, where it is now, or even sometimes at 4 percent. And, most critically, the Fed would be able to keep short-term interest rates well above 4 percent — where they are now — making it possible to lower rates substantially the next time it needs to stave off a recession or ease the impact of one.
Recall that starting with the great financial crisis of 2007-2008, the Fed found that lowering short-term rates to nearly zero wasn’t nearly enough to pull the economy out of the hole it had fallen into. So the Fed started to experiment with quantitative easing — the purchase of trillions of dollars of bonds and securities — and its intervention in the bond markets has never entirely stopped.
But in future economic downturns, the Fed would benefit if it started out with interest rates that were high enough for it to “respond vigorously with substantial rate cuts,” Mr. Ball said. That’s not going to be possible if both inflation and interest rates fall much further.
The Fed has its hands full, maintaining its independence and cementing its inflation-fighting credibility. But these longstanding thorny issues still need to be explored. The alternative may be more frequent recessions and greater job losses than would otherwise be necessary. The nation will be better off if policymakers aren’t entirely preoccupied with fighting the last war.
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