Is the Fed braking too hard?
By Paul Krugman
If you’ve ever found yourself driving in stop-and-go traffic, you know that there’s a strong temptation to overreact to changes in the flow. When the cars in front of you finally start moving, you floor the gas pedal, then you slam on the brakes when traffic slows down again, and if you’re a normal human being, you probably do this over and over.
Overreacting to traffic conditions wastes fuel and annoys your passengers. More important, it creates real dangers: Accelerate too fast and you may rear-end the car in front of you; brake too hard and you may be hit by the car behind you.
Well, setting economic policy in difficult times can be a lot like driving on a congested road. And I’m hearing growing buzz, both from economists and from businesspeople, to the effect that the Federal Reserve — which clearly kept its foot on the gas too long last year — is now braking too hard in compensation. And the risks of an accident are growing.
The story so far: Last year, as inflation began to accelerate, many people — myself included — wrongly minimized the risks, asserting that much of the inflation was transitory, the result of temporary kinks (such as disrupted supply chains) as we emerged from a pandemic economy. Over time, alas, inflation didn’t just rise; it broadened, spreading from a relatively narrow range of goods to much of the economy. It was hard to avoid the conclusion that the U.S. economy was running significantly too hot.
So the Fed began hitting the brakes. It didn’t start raising the interest rates it controls until March, but long-term interest rates — which are what matter for the real economy and reflect not just current Fed actions but expectations of Fed actions — have been rising since the beginning of the year. They’re now up about 2 1/2 percentage points, which is a lot by historical standards and well above the levels that prevailed on the eve of the pandemic; mortgage rates are higher than they’ve been since the 2008 financial crisis.
These rate rises will surely cause a major economic slowdown, quite possibly a recession. True, for the moment, the U.S. labor market is still running hot, with low unemployment and high levels of job vacancies and quits. (Workers are more willing to quit when jobs are abundant.) But there are well-known lags in the effects of monetary policy. It takes time for higher interest rates to reduce investment and for this investment downturn to spread to declines in consumer spending. And let’s not forget that government spending is no longer boosting the economy. Outlays from the American Rescue Plan, which was enacted early last year, are receding in the rearview mirror.
Now, the U.S. economy did need to cool off, so the coming slowdown doesn’t necessarily mean that the Fed is overdoing it. As I said, however, there is growing buzz to the effect that the Fed is braking too hard. As far as I can tell, this buzz reflects three main observations.
First, the Fed’s urgency in tightening largely reflects concerns that inflation might become entrenched — that people might begin expecting high inflation to persist for years and might build those expectations into price and wage setting. That’s what happened in the 1970s, and squeezing out those expectations was extremely painful.
But every indicator I know about shows expected inflation falling; the risk of a rerun of “That ’70s Show” now seems remote.
What about actual inflation? There are many private sector indicators of price movements, which often show breaks in trends well before they’re reflected in official statistics. And many of these indicators, from shipping costs to rents on newly leased apartments, seem to show inflation abating.
In an ironic role reversal, many of the people who correctly warned about inflation risks last year are now insisting that the recent good news is transitory, and some of it probably is. But a rapid decline in inflation looks more likely than it did a few months ago.
Finally, there’s growing risk that monetary tightening will produce not just a slowdown but an economic crisis — a crisis that would have a strong international dimension. For one thing, the fact that central banks are raising interest rates almost everywhere creates the danger of destructive synergy.
Also, Fed tightening has led to a large rise in the value of the dollar — a currency that still plays a special role in the world economy. And because of that role, a rising dollar often creates financial problems for other nations, which can blow back on the United States.
Do we know for sure that the Fed is braking too hard? No. The current economic situation is full of uncertainty, and any policy decision involves making trade-offs among various risks. What we can say is that the risk that the Fed is moving too slowly to contain inflation has declined, while the risk that high interest rates will cause severe economic damage has gone up — a lot.
Right now the Fed seems set to pursue further big rate hikes in the coming months. I would urge it to look hard at what’s happening and think twice.