The Fed not getting inflation back to its 2% target is heavily unideal (especially given that the Fed’s actual target -- based on flexible average inflation targeting -- is below 2%).
- The Fed’s credibility is really important for long-term economic stability. To prevent a future inflation from spiraling out of control as people and firms make early purchases to avoid the risk of future inflation, you need to believe the Fed will act.
- The function of a flexible average inflation target is that, in times of low inflation, you know there’ll be high inflation in the future and hence make a bunch of purchases now. In times of high inflation, you know inflation will go below 2% in the future, so postponing some purchases might make sense if the nominal interest rate exceeds expected future inflation, even if it’s below current inflation.
Unfortunately, it appears that getting to 2% is going to be really difficult. Jason Furman, former chief economist under the Obama Administration, summarizes empirical research by Larry Ball, Daniel Leigh, and Prachi Mishra, and says:
I assumed that the labor market will cool on its own as job openings fall two-thirds of the way back to what they were before Covid. I also assumed that inflation expectations will fall back toward where they were before Covid and that the recent good news on gasoline and other volatile prices will keep coming for the rest of 2022. Under these assumptions, which are more optimistic than the authors’ midpoint scenario, if the unemployment rate follows the Federal Open Market Committee’s median economic projection from June that the unemployment will rise to only 4.1%, then the inflation rate will still be about 4% at the end of 2025. To get the inflation rate to the Fed’s target of 2% by then would require an average unemployment rate of about 6.5% in 2023 and 2024.
Larry Summers, former Secretary of the Treasury and NEC Director, agrees. Summers, Olivier Blanchard (former IMF chief economist), and Alex Domash estimate that 5% unemployment is likely necessary to “get the labor market back into balance.”
Here’s the problem: according to the Sahm Rule, “the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to its low during the previous 12 months” only at the beginning of a recession. The current unemployment rate is 3.6 percent. That means a monetary policy tight enough to induce that much unemployment -- in itself incredibly, incredibly costly -- would likely induce a recession.
Paul Krugman is more skeptical, but his transitory inflation stories so far haven’t been great at prediction at all. Summers and Furman’s predictions have been more consistently right.
That puts the U.S. in an incredibly tough place. It has to choose between meeting the inflation target or avoiding unemployment much higher than it currently is, which would be devastating for the working class. In general, I think unemployment is more harmful than inflation -- but I suspect unemployment is still too low for inflation to be in control. Therefore, I agree with Furman’s conclusion: perhaps, for now, the Fed should aim for around 3 percent inflation. That’s a more realistic target, that maintains the Fed’s credibility somewhat, but also doesn’t induce staggering costs on poor workers.
