If You Drive Fast, You Have To Corner Harder

Some thoughts on our inflation situation

I’m not an economist. In fact, I’ve never even taken an economics course. Back when I worked in finance, my colleagues would periodically express surprise that I didn’t have some kind of technical background, whether in economics or mathematics or physics, but I never misrepresented myself to them. I’ve got a high school diploma, a B.A. in history, and that’s about it for formal academic credentials of any kind. Everything else I know—about the economy and the financial markets, about politics and international relations, about religion, or, for that matter, about Shakespeare or about filmmaking—I’ve picked up along my way through life in various ways. (To be fair, I did take some screenwriting courses at NYU after leaving finance.)

I put that preamble out there to formally give my readers permission to dismiss this post as the blathering of someone without the adequate training to properly evaluate macroeconomic policy. Because my point is this post is to argue that our macroeconomic policy is working pretty much the way it was intended to, and if we don’t like it that’s in part because all policy choices have downsides. There may well have been a policy that was easier to implement or politically safer, but I’m not sure there was a clearly more optimal economic policy as such. Moreover, if we take seriously our economic objectives circa 2020 and 2021 that drove our policy at that time, it’s clear what we need to do now: reverse harder on what we did then.

I’m not confused about the seriousness of our current economic situation. The United States is experiencing the highest inflation in forty years, and, far from moderating, inflation is still going up. This is our most important economic problem; it’s also the most serious political headwind the Democrats face, not only worsening their electoral prospects but frustrating their ability to enact much of their policy agenda. I’m very gratified to see new progress both on industrial policy—a bipartisan priority—and on climate change, but much of the Democrats’ redistributive agenda is clearly inflationary and is going nowhere in current economic conditions.

Why is inflation so high? Partly because of exogenous geopolitical factors like the war in Ukraine and the unwinding of our economic integration with China and a more general retreat from free trade. But a big part of the reason is that we poured a ton of money into the economy during the pandemic via direct fiscal transfers and via monetary expansion. That money has found its way into consumer demand that significantly outstrips supply, resulting in bottlenecks in particular areas and alarmingly high inflation overall.

Why is inflation such a serious economic problem? Primarily because of the way that expectations of inflation can become a self-fulfilling prophecy, and thereby drive an upward spiral. When people expect inflation, they buy now before prices rise, further goosing demand. They may even borrow to buy now in the expectation that the value of their debt will drop over time, goosing demand above income growth. If the situation persists, they may start demanding that inflation be built into terms of employment, resulting in an escalatory cycle where automatic wage increases drive further inflation which drives more rapid wage increases. Businesses, meanwhile, slash productivity-enhancing investment because inflation has made the long-term outlook too uncertain, and focus on extremely short-term wins. All of this does direct damage to the productive capacity of the economy and also makes it harder and harder for monetary policy to return to price stability and a platform for sustained real growth.

So how can I say that an economic policy that put us where we are might have been as optimal as any other choice? The reason is that it’s the economic policy that has rapidly driven unemployment back down to the historically low levels that obtained pre-pandemic, which is precisely what it aimed to do. Both the Federal Reserve and the Congress learned the lesson from the Great Recession that doing too little in response to a major economic shock could have terrible consequences in terms of long-term unemployment, reduced long-term growth and deepening economic inequality. So this time around, policymakers on all sides decided to risk overshooting rather than undershooting, and they overshot.

What does that mean, though, to say that they overshot? What I think it means is that they got unemployment back to the pre-pandemic baseline “too quickly.” I’m not trying to resurrect the Phillips Curve, which demonstrated its limitations in the 1970s, but there clearly is some degree of an inverse relationship between inflation and unemployment, at least in the short term. If the paramount goal was to restore the full-employment economy of 2019 as quickly as possible, that was inevitably going to risk some degree of inflation. And that implies that, if you aimed for a more balanced approach with less inflation, you’d have gotten back to full employment more slowly.

Another way to put this point would be in terms of nominal GDP growth. So-called market monetarists argue that the optimal policy for a central bank isn’t to target inflation at all, but to target stability in nominal GDP growth, because transactions are priced in nominal dollars and so stability in nominal growth means a maximally-predictable economic environment for businesses, employees, consumers, etc. There’s always the question of what level of stable nominal growth is achievable—that’s a function of things like population growth and technology-driven productivity advances among other things—but if that level does vary over time it should vary slowly, so in general targeting stable nominal growth should be doable. Now, the dramatic contraction in economic activity due to COVID was not the kind of thing that could be completely smoothed by any policymaker in D.C. “Stability” in that moment was impossible. But by the same token, since COVID was an exogenous shock, it wasn’t unreasonable to say that the policy goal should be to get back to the pre-COVID trend line as quickly as possible. In that regard, it’s worth noting that if you straight-lined nominal GDP growth forward from January 2020 (the last pre-COVID quarter), you’d wind up pretty much exactly where we are now. We’ve caught up to the nominal growth trend just as we caught up to the employment trend—which were our paramount goals. If we’re not happy with having done so, we’re implicitly saying that we should have gotten here more slowly.

So: should we have gotten here more slowly? It seems to me that that’s a political question as much as an economic one, and here’s why. My suspicion is that if we’d taken a more balanced approach in early 2021, we’d have risked not getting back to trend at all. Inflation would still have gone up, though likely not by as much, and resulted in similar political headwinds. Inflation takes its biggest bite out of middle-class wages, which is why it’s so politically painful. So in our hypothetical alternative world, I doubt there’d be any appetite for “stable” 4% or 5% inflation to get us back to trend. Meanwhile we’d still have the Ukraine war driving up the prices of energy and food, so even promising stable above-trend inflation would be foolish; who could deliver stability with Vladimir Putin aiming for instability. We’d be where we are now, in other words, trying to tame inflation, but with unemployment a point or two higher and nominal GDP a bit lower. Would inflation be easier to tame in those circumstances? Probably—in particular, the Fed could probably achieve its goals with a pace of interest-rate hikes that didn’t set new precedents such as they have been conducting. The landing would be softer. But I suspect we’d land at a lower level.

And that would have had lasting consequences. While inflation is taking a nasty bite out of everyone’s wages, the extremely tight labor market has already resulted in important gains for low-wage workers, job-switchers and teenagers entering the workforce. Going slower would have meant forgoing some of those gains—and if we had a softer landing at a lower point, might have meant forgoing them for a very long time. If we want a full-employment economy, that means not making that trade, but instead making the trade that we made in 2021: to drive the car as fast as we can to make up time.

But driving fast is also a policy choice with consequences. We don’t want to crash the car, after all. And if you drive fast, and don’t want to crash, then you have to corner hard.

I am disinclined to be too critical about the decision to push hard on the gas in 2021, notwithstanding that critics at the time like Larry Summers correctly predicted that it would lead to inflation. But I am inclined to be critical of the Fed for the pace of rate hikes since it was clear that inflation was not ephemeral. We’ve gotten all the way back to trend; at this point, the longer we let high inflation continue, the more economic damage we’re doing. The Fed might fear that faster and larger rate hikes would spook the market into thinking that inflation was even more out of control than it is, but I think that’s backwards. The market wants to see that the Fed is capable of responding to the speed and severity of economic conditions on the upside just as it wants to see that on the downside. It wants to see that the Fed can turn as fast as it drives.

Does that mean we’re going to tip into a recession? We’re probably already in one, but if we aren’t then of course it does. From an economic perspective, that’s not necessarily a disaster. If you look back to the full-employment economy of the 1950s, recessions were frequent, sharp and short. That might be what things will look like if we try to maintain a full-employment economy in the future as well. The “goldilocks” economy where the Fed maintains stable prices and low unemployment with little effort is probably only possible under rare conditions, with few exogenous shocks and, I suspect, a world-historical economic transformation in a major country driving global productivity markedly higher. In the world as it is, our choice is probably between making Washington’s job easier, and having a larger reserve army of the unemployed—or making Washington’s job a bit tougher, with sharper policy turns required on both the fiscal and the monetary side to steer us quickly back to full employment, and also quickly back to low inflation.

If we can’t do that—whether because our political system can’t handle sharp turns or because we don’t have the technical capacity to see economic reality quickly enough to respond properly—then we really do need to drive slower. We should just all understand that saying that means saying that we’ll get where we’re going slower as well—and the “we” in that sentence is first and foremost those who benefit most from a full-employment economy.