The Power of 'Nobody Knows'
What's happening to inflation? We know, of course, what the current numbers say: Inflation is high right now, although not 1970s high. But is this a blip or the beginning of a longer-term problem? Economists are deeply divided. I'm basically for the former, on what has come to be known as Team Transitory, but I might be wrong -- and the data are sufficiently ambiguous that both sides can claim that the evidence supports their take.
Yet policymakers can't just shrug their shoulders; they have to, um, make policy. So what should they do in the face of uncertainty? The answer, I'd argue, is to make decisions that won't do too much damage if their preferred take on inflation is wrong.
In the current context this means that the Federal Reserve should ignore calls for a quick tightening of monetary policy.
Why is it so hard to make a call on inflation right now? Because the current economy, still very much shaped by the pandemic, is, to use the technical term, weird. In particular, the standard measures economists use to distinguish between temporary price blips and underlying inflation are telling different stories.
The traditional measure of underlying inflation is the rate of change in the "core" price index, which excludes volatile food and energy prices. But there are alternative measures, like the median (as opposed to average) change in prices, which excludes drastic price moves in any sector.
During the last economic crisis it didn't matter much which measure you used. All of them had the same message: Don't panic. For example, when headline inflation was running hot in the winter of 2010-11, leading Republicans berated Ben Bernanke, the Fed chair, for loosening credit, warning that easy money might "debase" the dollar. But measures of underlying inflation were low and stable:
So the Fed stayed the course, and it was right.
These days, however, the different measures are telling very different stories:
A few months ago core inflation was looking high, driven by things like used-car prices -- which clearly don't represent underlying inflation, but are still part of the standard measure -- while median inflation was subdued. More recently, core has subsided, but median inflation -- mainly reflecting shelter prices -- has surged.
So how serious is the inflation problem? We can argue about that, but maybe the crucial point is that nobody is going to win that argument in time to give helpful guidance to policymakers. Sorry, but ranting on cable TV and tweeting in CAPITAL LETTERS aren't going to settle this.
So what should guide policy? I'd suggest that we heed the advice of Oliver Cromwell: "I beseech you, in the bowels of Christ, think it possible you may be mistaken." (OK, you can maybe skip the gastroenterology.)
Consider, as an example of what not to do, the fate of the Obama stimulus package that was enacted in 2009.
It's now clear that while stimulus was necessary, the actual plan was much too small and short-lived (as some of us warned at the time). Why the undershoot?
Part of the answer is that the administration's economic forecast was excessively optimistic, envisioning the kind of quick recovery that rarely happens in the aftermath of financial crises. But the larger problem was a failure to think through what would happen if the forecast was wrong.
If the stimulus had turned out to be too big, that wouldn't have been a big problem: The Fed could have raised interest rates a bit to head off overheating. But if the stimulus proved too small, the Fed couldn't cut rates because they were already zero. So then what?
A memo from Larry Summers, Barack Obama's top economist, suggested that the president could simply go back to Congress for more: "It is easier to add down the road to insufficient fiscal stimulus than to subtract from excessive fiscal stimulus." But this was a wild misjudgment of the political landscape -- again, something some of us warned at the time.
The point is that the Obama team messed up -- not by making a bad forecast, but by failing to understand that the risks of going too small were much higher than the risks of going too big.
What does that say about our current situation? Fiscal policy is pretty much off the table: Whatever the fate of President Biden's spending plans, they aren't likely to have much impact on short-run economic developments. So the question is about Fed policy. Should the Fed raise interest rates soon, to head off inflation, or wait and see whether recent inflation proves transitory?
There are risks both ways. If the Fed waits, inflation might become embedded, and bringing it back down again could be painful -- though doable. On the other hand, if the Fed raises rates to head off an inflation problem that proves exaggerated, it could damage the economic recovery in ways that are hard to reverse. (Interest rates are still very low, so there would be little room for cuts if the economy weakens.)
So wait-and-see looks like the prudent thing to do. I think current inflation is transitory, but I'm not sure. I am, however, confident that tightening monetary policy based on what we know now would be a big mistake, because the risks of moving too soon and moving too late are highly asymmetric.
In short, don't just do something. Stand there -- at least for now.