opinion | Higher prices for fewer jobs: The Fed weighs inflation and stagnation

Under Volcker, the Fed has finally set its proverbial footing. interest rates rose; Businesses that once relied on debt financing—including construction and car sales—are broken; The unemployment rate reached 10.8 percent, a level that would not have been repeated until the global financial crisis. But it worked: the rate of inflation fell from 13.5 percent in 1980 to 3.2 percent in 1983.

This story is usually told victorious – brave Volker, takes the painful but necessary steps! However, now that our Fed Chairman may be facing a similar ugly trade-off, I admit that I’m thinking more about the deep pain the recession has caused. Of course, it is bad to lose 8% of your purchasing power due to inflation. But it is even worse to lose a hundred percent of it to unemployment – and the collective suffering of those who have lost their jobs is arguably far greater than the pain of families pressed by inflation.

So I asked John Huizinga, who taught me macroeconomics 20 years ago at the University of Chicago’s Booth School of Business: Why is stagnation better than high inflation? His answer, in short: It is not. “If it were me and I was in charge of monetary policy, would I cause a major recession to keep inflation low? No, but I would try to reach a stable inflation rate, and then reduce the inflation rate gradually over time.”

To understand what it leads to, imagine knowing that each year, inflation will be exactly 10 percent. This is a very high rate of inflation, but if everyone knows what it will be, we will develop ways to mitigate the impact. Interest rates on bonds and savings accounts will rise to offset the inflation losses. Employment contracts specify annual increases of 10 percent in the cost of living. Social Security and pension checks will have similar adjustments built in.

Now compare that to the unexpected 10 percent, which is close to what we’re seeing now. Suddenly everyone’s grocery budget went up, savings lost a good part of their value and people worry about being able to put gasoline in the car. This is a completely different phenomenon, and much worse, because it makes it impossible to plan our financial lives.

“We haven’t moved to a new equilibrium in which the amount of inflation is expected,” Huizinga says. “This is the worst kind of inflation because it means we make bad decisions every day.” If we had known, we would have put mitigation measures in place. Instead, we’re overwhelmed by costs we didn’t plan for.

Now, it is clear that it would have been better if inflation had not occurred at all, since these adjustments would be imperfect; A person who invested his life savings in a fixed annuity before inflation took an 8 percent premium of its value is now permanently worse off. Moreover, the very adjustment mechanisms that help people offset the cost of inflation can make it difficult for the Federal Reserve to control inflation. If companies expect costs to rise 5 percent next year, they will demand higher prices to offset the increase, and if workers expect higher prices, they will demand higher wages, which translates into higher costs for companies. When expectations of monetary policy become “unstable” in this way, inflation feeds on itself.

But in the absence of a time machine, it is too late for inflation to not occur. So what to do now? What do we do now?

I agree with my old professor that the best thing the Fed can do is stabilize inflation and then bring it down. I just wonder if that is possible. For one thing, it may already be too late to avoid stagnation; We’ve already seen a quarter of negative growth. But the bigger mystery is whether the Fed can announce a high but stable inflation policy and make it consistent.

After decades of reliably maintaining a 2 per cent inflation target, could the Federal Reserve suddenly announce that it would allow inflation to stay high – but not higher? Or will future inflation expectations slip from their fulcrums and move towards the stratosphere? Would it be politically possible for the Fed to stay on this path, with anxious Americans asking Congress to do something (such as appointing inflation hawks to the Board of Governors)? It may be that for all its costs, the Volcker route is still the best option available to us, given political constraints – although if it does, that’s all the more reason for the Fed to make sure inflation doesn’t just go down, It remains so. a little.

“If you let inflation start again, who knows how quickly people will start to anticipate it?” Huizinga says. And no matter how you do it, “it’s very expensive to break this cycle.”