Don’t Leave The Fed Alone To Fight Inflation

Relying on the Federal Reserve to deal with inflation by itself could throw Americans out of work and lower their standard of living — and possibly trigger payment crises or sovereign debt defaults around the globe.

Xiao Hua Yang for Noema Magazine

Alex Williams is a senior economist at Employ America.

With measured inflation at its highest levels in 40 years, policymakers and commentators are sounding the alarm. State governments are debating whether to roll out further stimulus programs to help Americans hard-hit by rising prices, and the question of what to do about inflation is dominating public discourse. So far, the strategy from policymakers has been to leave inflation control largely up to the Federal Reserve. After all, no other government agency is explicitly tasked with inflation management.

Yet when inflation spikes, the Fed has very few tools that act directly on the sources of the problem. What they can do is raise interest rates — higher interest rates are meant to discourage businesses from investing and hiring.

That discouragement is supposed to ease inflation by restricting consumption and demand by limiting the income of workers through rising unemployment and falling wages. In such a climate, companies have an incentive, in theory, not to raise prices. But this comes at a cost: even if this approach creates disinflation or deflation, it will do so by throwing Americans out of work and lowering their standard of living.

If production bottlenecks in a single sector — or a handful of sectors — are driving inflation, the Fed can only intervene in those sectors by slowing down the entire economy. Rather than widening or breaking these bottlenecks, the Fed can only try to shrink the economy enough that the entire thing can fit through the bottleneck. Relying on the Fed to resolve inflation by itself means committing to this mechanism on the heels of one of the deepest labor market recessions of the last hundred years.

From an international perspective, this singular reliance on the Fed to manage inflation through interest rate hikes creates additional problems. The interest rates set by the Federal Reserve are key benchmarks against which USD liquidity is offered internationally. While the Fed may be aiming at the domestic economy, it can’t help but send ricochets around the world. A tightening cycle designed to slow inflation domestically generally tends to make hard currency more expensive abroad.

“Rather than widening or breaking these bottlenecks, the Fed can only try to shrink the economy enough that the entire thing can fit through the bottleneck.”

Even without an energy shock and a potential food price shock, incremental interest rate hikes by the Fed tend to increase the likelihood of balance of payment or sovereign debt crises in a number of emerging markets. In countries where domestic industries rely heavily on imported capital or intermediate goods, higher interest rates in the U.S. tend to mean higher input costs. For countries that are reliant on imports for food and energy — such as Morocco and other North African countries — a stronger dollar means rising costs bite even harder.

But the Fed doesn’t have to go it alone. Even with a hamstrung legislature, the administration has tools it can use to slow down inflation.

Why The Fed?

There are good, historical reasons why policymakers assume that managing inflation is the sole responsibility of the Federal Reserve. The “dual mandate” laid out in the Humphrey-Hawkins Act of 1978 established the Fed’s core economic responsibilities as ensuring “full employment” and “price stability.”

But that dual mandate can be both quantitatively and conceptually vague. Over the pandemic, the Fed has repeatedly failed to provide an exact account of the metrics it uses to determine whether or not the economy has reached full employment.

The same is true for “price stability.” In recent decades, the Fed has targeted yearly inflation rates of 2%, as measured by core personal consumption expenditures (PCE). This indicator excludes volatile food and energy prices and uses a slightly different set of definitions than the more commonly seen consumer price index (CPI). However, early in the pandemic, the Fed completed a framework review and switched to “flexible average inflation targeting.” So far, this new framework has not proven much clearer to market participants than “full employment” had. Ultimately, since the Fed seeks to govern interest rate markets over which these market participants also have substantial control, it must be sensitive to a wide range of indicators for inflation and labor market strength.

Some academic economists have even suggested that the Federal Reserve and Treasury should trade statutory mandates with one another. Under this arrangement, the job of fiscal policy would be to ensure full employment and price stability, while it would be the role of monetary policy to establish debt sustainability. This may sound strange, but there is some empirical support for this approach. We’ve seen over the pandemic that fiscal policy can move the economy back to full employment much more quickly than monetary policy. Recent decades have also shown that interest payments made by the federal government are far more sensitive to the interest rate than the deficit.

Inflation Narratives and Inflation Data

To understand which tools beyond rate hikes could help slow the increase of prices we have to think through the where and why of today’s inflation. As inflation has persisted, two major narratives have taken hold.

On one side, there are the arguments that the problem is labor supply. In this telling, the government was too generous with stimulus money throughout the pandemic, and as a consequence, nobody wants to work. This is an incredibly durable talking point, not least because it is consistent with the old explanation of inflation as a problem of “too much money chasing too few goods.” Presumably, if more people were working, there would be more goods. But this story doesn’t hold up in theory or in practice. In theory, hiring more workers boosts demand more quickly than supply, as the newly hired look to spend their wages. In practice, over a year since the most recent stimulus payment, the unemployment rate is nearly the same as it was before the pandemic.

“Even with a hamstrung legislature, the administration has tools it can use to slow down inflation.”

On the other side, inflation is considered a problem of widespread supply chain disruption. While this is a more accurate account, its complexity makes it much more difficult to convey. In a pithy phrase: for want of a nail, the rider was lost, and for want of a rider the kingdom was lost. Rolling lockdowns and mass illness caused factories to close at home and abroad, slowed logistics and created dramatic uncertainty about the composition of demand and the availability of intermediate parts for production. The problems were worse in longer supply chains — the impacts often multiply, rather than simply add — as serious disruptions in semiconductor and automobile production demonstrated. Quick-changing sectoral rotations also made it far more difficult to plan necessary hiring and investment. During the pandemic, tech companies hired employees on surging valuations as more Americans were staying at home and signing up for services. At the same time, employment and valuations in service-driven sectors collapsed. As vaccines rolled out, the two traded places, leading to substantial confusion today about investment and hiring pathways.

Looking at the data through the lens of this story, we see inflation proceeds through a few distinct stages. In the beginning of the pandemic, measured inflation fell as consumers sharply curtailed spending on services. In early 2021, bottlenecks in specific sectors — most especially automobiles — drove outsized increases in inflation while most components of the inflation index remained within normal bounds. In late 2021, price increases began to broaden, followed by a few months of narrowing. At this point, Russia invaded Ukraine, sending shockwaves through energy markets and triggering a fresh round of inflationary pressures. The jury is still out on the long-run path of inflation today, as spikes in the cost of energy tend to increase production costs while decreasing consumer demand.

Yet what this inflation chronology does not tell us is why those specific prices increased. Most sources of inflation were due to sector-level dynamics that, while individually unique, can uniformly be traced back to a history of underinvestment and pandemic disruptions. Increases in the price of durable goods, new and used autos, and a wide range of other goods find their origin to the semiconductor shortage and disruptions in logistics and transportation. In services that are seeing higher rates of inflation — particularly leisure and hospitality — there has been a substantial net loss in employees at the sector level since the beginning of the pandemic. While the current energy crisis starts with the invasion, the fact that U.S. oil producers have not begun to make up for the supply loss can be traced to negative oil prices in 2020, among other shale oil crashes.

Ensuring that these problems don’t return in the future would require legislation, which will take time to implement. In the long term, the government will have to take a more active role in guiding investment through the climate transition. Today, the U.S. government lacks much of the data necessary to directly monitor supply chains, let alone monitor them in real time. The flagship Input-Output statistics produced by the Bureau of Economic Analysis are only updated every five years. Several legislative proposals — USICA, COMPETES, and the Bipartisan Innovation Act — have included funding for this kind of supply chain surveillance, but we have yet to see any become law. However, this does not mean the administration’s inflation toolkit is empty.

What The Administration Can Do Today

Despite recent movements in the price of energy and food, the bulk of today’s inflation comes from an acute shortage of physical capacity in capital-intensive sectors like energy, housing and semiconductor production.  In each of these areas, uncertainty about future demand has led private firms to continually cut capacity since the 2008 financial crisis. During the pandemic, this diminished physical capacity led to higher shipping prices, longer lead times and vanishing availability for certain goods, laying the groundwork for today’s inflation.

Policymakers can address inflation today by making direct investments to expand productive capacity — and by funding the production of commodities whose short supply is causing slowdowns in those industries. In the long run, this investment will pay off in the form of stable near-term prices while making our economy resilient to future shocks.

Take housing, for example. We’re currently facing a deficit of nearly 4 million homes, which contributes to the pressures driving up housing prices. Construction has ramped back up since the early pandemic — more than 1.6 million housing units are currently being built and bringing them to market could help relieve pressures that are driving up rents. But shortages in imported materials like plastic resin and aluminum are keeping these units from being completed, creating a massive backlog.

“Any attempt to constrain domestic inflation by other means will help protect the world from the international consequences of rising interest rates.”

Congress and the executive branch could ease the bottleneck in a targeted way by investing in the domestic production of those materials. And longer-term, lawmakers could further shrink the housing deficit — lowering housing prices overall — through measures that fund new housing, like the Low Income Housing Tax Credit and the Housing Trust Fund. They provide state and local governments with funding to purchase, improve, maintain and build low-income housing.

The government has a number of other tools at its disposal that it could make use of more or less immediately to address these kinds of bottlenecks. As the Fed’sattempts tofight inflation slow down the economy, any attempt to constrain domestic inflation by other means will help protect the world from the international consequences of rising interest rates.

The Treasury Department could call on the reserves in the Exchange Stabilization Fund, which have been set aside to stabilize the dollar in the face of turmoil in international currency markets, to finance the production of commodities — the aluminum needed for housing, for example, as well as metals like palladium and copper, potash for fertilizer and crops like wheat.

The Biden administration should use the Defense Production Act to boost manufacturing of housing inputs, semiconductors — which would bring down the price of consumer electronics and cars — and materials needed for energy production like steel pipe and fracking sand.

The Bipartisan Innovation Act, which has passed in the Senate and needs to be approved by Congress, also contains funding for semiconductors, as well as funds for innovation that could break down barriers to expanding 5G. Such an expansion would foster competition among cellular service providers, driving down prices.

Although controversial in some quarters, accelerating the domestic production and refinement of oil and gas is critical for driving down inflation.

The Biden administration recently took an important step to accelerate investment in this sector. The Department of Energy will soon make it possible to enter into fixed-price contracts — including physical put options — with private oil producers to refill the Strategic Petroleum Reserve. This offers guaranteed demand as a buffer from fluctuating prices and an incentive to invest in expanding production now. Rather than relying on volatile markets and investment “supercycles” to drive energy production, the SPR will soon have a means of helping directly govern the market as a whole.

“The Fed’s tools are blunt and imperfect and have a history of exacting heavy costs on the labor market, investment picture and economy at large.”

But we can only benefit from these production increases if we preserve existing energy production capacity. The administration must keep refineries open and prevent the closure of nuclear power plants, while Congress should push for investment in energy infrastructure — especially since, as the Fed slows down the economy, private companies will be discouraged from making these investments. If this doesn’t happen, we can expect more statewide power outages in our future and greater refinery costs that get passed on to consumers.

While incentivizing increased domestic oil production may strike many as counterproductive with respect to climate, the opposite is actually true. The program incentivizes new drilling in shale wells, which run out of oil in 18-24 months, unlike much longer-lived traditional or offshore oil wells. More importantly, emissions come from the point at which oil is burned, not drilled. By keeping oil in the SPR’s salt caverns rather than yet-to-be-drilled leases, the government would have greater leverage to intervene in the market as a whole. The proposed rule change could also play an important role in ensuring that the price of oil never falls far enough to disincentivize decarbonization.

Alongside targeting bottlenecks by increasing capacity, the government can fight inflation by directly intervening on prices in health care and education, sectors where it can have a big direct impact on costs, and by fostering competition in telecommunications and air travel, sectors where regulatory uncertainty is preventing the adoption of new technologies that can lower inflation.

Americans already pay more for health care and higher education than those in any other advanced economy. Provisions in the new Inflation Reduction Act to allow negotiation on some drug prices are a substantial step in the right direction. Beyond that, standardizing Medicare fee schedules regardless of where a service is performed could reduce prices, while giving insurance providers more leverage to lower deductibles and premiums in the long run. Similar reductions were found to help weaken inflation between 2014 and 2016, according to the Chicago Fed. The federal government is also the source of a significant chunk of college revenue — some 15-30%, depending on whether the institution is private or public — and could tamp down education prices by making federal funding conditional on limits to tuition increases. 

Lawmakers can also fast-track a resolution to hurdles standing in the way of competition. The rollout of 5G cell service has been hampered by the fact that the frequencies used in providing 5G service conflict with those used by some radar altimeters, which are used to help planes land safely. A regulatory decision could clear up which players — telecoms and air travel — must make new investments to accommodate the new technology. On the telecoms side, an expansion of 5G coverage could show up as a “quality adjustment” from the perspective of inflation measurement. This would likely — as unlimited data plans did in 2017 — translate into lower measured inflation.

Funding for airport gate expansion would help lower the barriers to entry for lower-cost airlines to enter the market, keeping prices lower in a way that could offset increased fuel prices and robust demand as Americans look to make up for lost vacations.

Inflation is complex. Our economy today has more moving parts — and more interlinkages — than ever before. This makes it difficult to see what causes what, yet that difficulty should not justify a decision to leave the entirety of inflation management to the Federal Reserve. The tools they have are blunt and imperfect and have a history of exacting heavy costs on the labor market, investment picture and economy at large.

Instead, there is much that other branches of government could be doing. Measured inflation has reached levels not seen in decades, but there are nearly as many causes as solutions. We should use a broader set of targeted tools to address it.