Monetary policy works – current round of inflation proves

Policymakers have great power over the economy, at least in the short term. A famous study by David and Christina Romer studied Federal Reserve minutes to identify episodes in which the Fed deliberately sought to slam on the economic brakes or step on the accelerator. They found that what the Fed wants, the Fed gets. But power isn’t the same as precision. The Fed normally tries to manage the economy by setting targets for short-term interest rates, which it has no trouble achieving. But suppose the Fed raises its interest rate target by one percentage point. This will surely, other things equal, lead to fewer job openings, lower inflation and probably a rise in unemployment. But how big will these effects be? Nobody is really sure. Fed officials, I’m sure you’ll be reassured to hear, know what they don’t know. That’s why they constantly say that their policy is “data-dependent” — they’ll adjust their actions based on what they see happening. But keeping a close eye on the data isn’t as helpful as it might seem. For one thing, much economic data lags months behind the actual state of the economy and is subject to frequent revisions. Even more important, changes in policy don’t have immediate, visible effects. Think about one of the main ways Fed policy affects the economy: via housing construction. A hike in the interest rates the Fed controls may not immediately filter through into a rise in mortgage rates; higher mortgage rates take time to show up in reduced housing starts and even longer to show up in a decline in the number of homes under construction; and the effects of reduced construction on things like retail sales add yet another lag. Because of all these lags, policy that is too data-dependent — that reacts strongly to the latest numbers — can end up being destabilizing. Milton Friedman is said to have used the metaphor of “the fool in the shower,” who is alternately frozen and scalded because he’s constantly adjusting the taps in response to the current water temperature. So where are we now? The Fed began raising rates in March 2022; almost every economist I listen to agrees that it was right to do so. But the job market still looks strong, and inflation is still above target. Does this mean that the Fed hasn’t done enough? Maybe. But it’s also possible that the Fed has already done too much but we haven’t yet seen the effects of past rate hikes. I know perfectly reasonable, well-informed economists holding both views. Here’s where the metaphor of the soft landing actually works pretty well. Imagine a plane that is physically capable of making a smooth descent and touching down gently. But the pilot is trying to navigate through heavy fog with minimal visibility, and the instrument panel gives only an unreliable estimate of the plane’s altitude five minutes ago. Obviously it’s easy to see how the plane might either make a crash landing (i.e., experience a recession) or overshoot the runway entirely (suffer persistent inflation). So can we manage a soft landing? Between the possibility that inflation will be sticky and hence hard to bring down, and the difficulty policymakers will inevitably face in sticking the landing, it’s hard to give us better than even odds of pulling it off. But maybe we should step back and take the larger view. Covid-19 was an enormous shock to the economic system, made worse by Russia’s invasion of Ukraine. Yet we made it through the pandemic recession with remarkably little widespread hardship — in the fall of 2021, according to a Federal Reserve survey, 78 percent of Americans reported that their financial situation was at least OK, the highest percentage since the survey began in 2013. (We don’t yet have results for 2022.) That’s a huge success story and will remain a success story even if our landing is bumpier than we’d like. The job market is so strong that even if we have a temporary rise in unemployment, it won’t create that much hardship. Inflation is above target but nonetheless at a level Americans found quite tolerable in the past, so if it persists longer than the Fed would like, that won’t be a disaster. Unless we have a really, really hard landing, the overall story of the postpandemic economy will be one of remarkable resilience.