The Dangerous Midpoint of the Inflationary Pendulum
The Fed is Winning Its Battle with Inflation, but the Fight Must Continue
“…It is also a psychological fact of life that the risks almost always seem greater in raising rates than in lowering them. After all, no-one likes to risk recession.”
Paul Volcker
Former Chairman of the Federal Reserve Board
The U.S. Bureau of Labor Statistics (BLS) reported that inflation increased by 0.4% in April 2023 and 4.9% over the prior 12-month period, thus continuing the trend of disinflation that began in April 2022. The inflationary and monetary policy paths continue to resemble those that Americans experienced in 1919-1920 following the conclusion of World War I and the Great Influenza pandemic. For more information about the similarities, I recommend reading this paper.
Sources: U.S. Bureau of Labor Statistics; Federal Reserve Board.
The Federal Reserve appears to have the upper hand in its battle with inflation, but it is too early to declare victory. To do so would repeat the errors of William McChesney Martin, Jr. and Arthur Burns in the late 1960s and 1970s. Their premature abandonment of efforts to contain inflation allowed high inflation expectations to become entrenched in the American psyche. This is why draconian monetary policies and a painful recession under Chairmen Paul Volcker were necessary from 1979-1982. It is also why a recession remains the most likely outcome before the Post-Covid-19 inflation comes to an end.
The Rules of the Inflation Game
In July 2022, my son and I paid a visit to the Bank of England Museum. In addition to having an opportunity to hold a gold bar worth several million dollars, he enjoyed playing with the exhibit, called the Inflation Game. The goal is to balance a steel ball at the mid-point of an air tube denoted with a 2% inflation marker. The player — or an annoying father — then pushes an “economic shock” button that shakes the tube, dislodges the ball, and sends it to either the extreme right, which represents inflation, or to the extreme left, which represents deflation. My son struggled to return the ball to the target, overshooting several times before getting it to settle back on 2%.
The Inflation Game is a perfect metaphor for the Fed’s current predicament. The massive economic shock in March 2020 sent the ball careening to the left. The Fed and the federal government responded by flooding the economy with liquidity to ward off extreme deflation and a potential depression. Then, in 2022, after the excessive stimulus had shifted the ball too far to the right, leading to high inflation, the Fed reversed course. Now, the Fed is attempting to bring the ball to rest at the 2% target, but inflation is likely to dip below 2% before price stability returns. This will likely be accompanied by a recession. Alternatively, the Fed could prematurely loosen monetary policy and repeat the mistakes of William McChesney Martin, Jr. and Arthur Burns. This is just the nature of the inflation game.
Future Outlook
The Federal Reserve is unlikely to make the same mistakes as Martin and Burns, and they have clearly indicated this in their statements to the public. This means that the most likely outcome is that they will overshoot in the opposite direction and trigger a recession. Nevertheless, the short term pain is necessary to ensure a return to price stability and economic prosperity in this country. So, Americans would be wise to brace for recession but also be thankful for the Fed’s commitment to nip inflation in the bud. The alternative would be much worse.