Now Is No Time to Raise Interest Rates

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With year-to-year inflation now at 40-year highs, part of the debate is settled: Inflation is higher and longer-lasting than the Federal Reserve or the Biden administration expected. That they and so many other economists failed to anticipate the inflation we are seeing creates a worrying air of mystery. If we don’t understand why inflation is so high right now, wouldn’t it be prudent to begin hiking rates? The reality is that the inflation mystery is not so mysterious, and should have been expected. Once you understand the why, a strong case can be made that the Fed should not panic—and stick to its plan to keep rates low.

Three main factors have driven inflation over the past year: fiscal stimulus, tight labor markets, and supply-chain problems. All three of these will dissipate over the next year or two. What is required, then, is not prudence but patience.

Early in the coronavirus pandemic, fiscal spending was not about stimulating the economy but keeping the lights on for households and businesses. However, by early 2021 it was relatively clear that the reopening of the economy was on the way and that household incomes in 2020 were actually above normal. In this environment, spending was no longer justifiable as relief but as stimulus. Unfortunately, as a stimulus it was poorly structured. The problem was not so much the amount but the speed and timing. Because so much of the $1.9 trillion stimulus was distributed all at once, its immediate fiscal impact was a massive 7.6 percent of GDP in the first quarter of 2021. That impact has faded, however, and will continue to fade further into 2022.

Another issue was not just the size of the impact but also the state of the economy in which it was felt. In an economy where in-person services were still mostly shut down, sending big, onetime checks to people not only pushed demand above the supply, but also ensured that spending largely went into already capacity-constrained goods sectors, such as furniture, household improvements, and consumer durables. Manufacturers that were already stretched thin could and would expand only so much to match what they knew was short-term, pandemic-driven demand; predictably, this pushed inflation in the goods sector even higher.

It would have been better to spread the $1.9 trillion over several years, at a more gradual pace, in the form of smaller but ongoing quarterly stimulus checks. But it’s too late for that now. The good news is that, along with the fading fiscal pressure, spending will also continue to rebalance away from goods and toward services, which will help reduce price pressures on goods.

The second factor is tight labor markets. Earlier in the year, anecdotes about employers having a hard time hiring were met with some skepticism, given that millions remained out of work. As job openings surged and wage growth moved higher and higher, these anecdotes have been borne out by data. However, it is crucial to recognize that this tightness is temporary, driven by a variety of factors holding people back from working. For much of the year, expanded unemployment that paid many people more to stay home than to work played a role. When that expired in September for most states, high levels of household savings, due to both expanded unemployment insurance and stimulus checks, continued to keep workers on the sidelines. Both factors interact with other issues, such as trouble finding child care and fears of an unsafe work environment owing to COVID.

All of the major factors that have reduced labor supply will fade. The unsustainable nature of the shortages, for example, is evident in the fact that shortages and fast wage growth are mostly occurring for the lowest-paid workers—and these are the workers least likely to be able to simply decide they don’t want to work anymore. As the factors holding back labor supply continue to recede, we will be left with a labor market that has millions of people wanting work, and there will once again be more workers than available jobs instead of the reverse.

It’s also important to recognize that the pre-pandemic labor market is not a useful benchmark for a tight labor market. Compared with the late 1990s, the labor market in 2019 was still missing about 1.6 million workers aged 25 to 54. Nothing changed from the late 1990s to 2020 that should cause a smaller share of the prime working-age population to work. And indeed, the more educated workforce of 2020 compared with that of 1990 likely means that even more people should be working. This measure also happens to have been the best indicator for predicting where wage growth was headed pre-pandemic. If you focused on the share of prime-age people employed, you were not surprised that wage growth kept rising and that the labor market grew stronger. If you focused on unemployment, quits, or other indicators, you were consistently surprised that the economy never arrived at anything like full employment. We should not repeat that mistake again.

The final factor is the supply chain. Although some of these problems are industry-specific issues that are slowly being worked out with time, like the lack of chips used for automobiles, others are a result of an interaction of the first two problems. Large stimulus checks drove demand way above normal for goods, and labor shortages make it even harder for manufacturers to make things and for distributors to move them. As a result, as both demand and supply normalize, many supply-chain problems will settle down too.

It may be tempting to blame supply-chain problems on a few distinct bottlenecks, such as the chaos at the ports or the lack of truck drivers, but it’s not that simple. In a sense, you can think of supply-chain problems as a bit like a middle-aged economist who decides to start playing competitive rugby. It is a near certainty that they would sustain a rugby-career-ending injury in a relatively short time. And although that specific injury would be the direct cause of their sidelining, it would be a mistake to presume that a rolled ankle, concussion, or broken rib is the thing that stopped them—rather than the mistaken decision to play in the first place. If that injury didn’t stop them, another soon would. The same is true of pushing demand for goods far above normal while the labor supply is restricted: Under these conditions, some point in the supply chain was bound to become a binding constraint. Fortunately these supply-chain problems should therefore lessen as the rest of the economy normalizes.

Although the factors pushing inflation high will continue to fade, it’s unclear when the pace will slow to tolerable levels. Inflation certainly won’t disappear overnight. Rental-price growth is high, and this will continue to affect the consumer price index for some time. Nevertheless, the Fed should be patient. Although inflation is high now, past episodes of runaway inflation did not manifest in one or two years; they were a result of years and years of policy mistakes and economic trends. If we are to have a long-run inflation problem, it will take much longer to show up. For now, we should continue to assume it is transitory. If price pressures do not begin to weaken in 2022, then it would be time to begin raising rates. The Fed has plenty of time to hike rates later.

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