Will the Fed repeat the mistakes of the Great Inflation?

As America’s central bank, the Federal Reserve has a legal mandate to foster maximum employment and price stability. Over the past year, however, the Fed has watched passively as the unemployment rate has plummeted and inflation has surged upwards.

Even if the Fed starts raising interest rates above zero and engages in a few quarter-point hikes this year, monetary policy will remain extraordinarily accommodative. Unfortunately, the Fed has already fallen far behind the curve in responding to inflation developments.

While economists have plenty of disagreements, there is practically unanimous agreement that the stance of monetary policy should be assessed in terms of the inflation-adjusted interest rate — that is, the difference between the actual federal funds rate and the underlying trend of inflation. In fact, this measure is such a fundamental concept that economists refer to the inflation-adjusted interest rate as the “real interest rate.” 

The Fed held the federal funds rate target at zero throughout 2021, even as its preferred measure of underlying inflation (the price index for personal consumption expenditures excluding food and energy) moved upwards rapidly. Consequently, the inflation-adjusted interest rate, which was moderately negative last January, declined sharply over the course of last year.

In effect, the stance of monetary policy became far more accommodative even though unemployment was dropping and inflation was rising rapidly. The inflation-adjusted interest rate has now reached a historic low of –5 percent, even lower than at any point during the Great Inflation of the late 1960s and 1970s.

Nonetheless, Fed officials appear to remain sanguine about the near-term inflation outlook. In their latest set of forecasts released a few weeks ago, Fed officials projected that inflation will soon start heading downward and subside to an average rate of about 2.6 percent this year. That outlook provided the rationale for assuming that appropriate monetary policy would involve only a handful of interest rate hikes this year. 

In light of the Fed’s abysmal forecasting track record, however, it seems unwise to continue following a policy strategy that hinges on forecasts rather than actual economic data. A wide array of indicators confirm that elevated inflation has become firmly entrenched and is unlikely to dissipate anytime soon.

One key component of the consumer spending basket is the cost of housing (which includes rental rates as well as owner-equivalent rent). That component has been accelerating to an annual rate of around 5 percent and is likely to pick up even further.

Global supply chains remain tangled, partly reflecting the spread of new variants of COVID-19 and diminishing the prospect of any imminent decline in manufactured goods prices. And the New York Fed’s household survey indicates that consumers anticipate that inflation will most likely remain close to 5 percent three years from now.

Moreover, recent developments have triggered the same feedback loop between wages and prices that was last observed during the period of the Great Inflation. The average hourly earnings of ordinary workers grew by 6 percent over the past year, but that was barely sufficient to keep up with the rising cost of living. And businesses with tight margins have no alternative but to pass those wage increases along in the form of higher prices for their goods and services. 

To mitigate the risk of an upward inflationary spiral, the Fed must move promptly in shifting to a neutral stance of monetary policy. In particular, to bring the inflation-adjusted interest rate back above zero, the level of money market rates must be brought into alignment with the underlying trend inflation rate. Once monetary accommodation has been removed, the Fed will need to be attentive to both parts of its dual mandate in the process of ensuring that inflation returns to its 2 percent target. 

Thus, planning on just a few quarter-point rate hikes over the coming year would be grossly inadequate. For example, in the benign scenario where underlying inflation heads downward to a plateau of 3 percent, the inflation-adjusted interest rate would remain deeply negative — in fact, lower than at any point during either of the past two recessions.

And in scenarios where inflation remains near its current level or heads further upwards, the Fed would fall even further behind the curve. Achieving a neutral stance of monetary policy will almost surely require the Fed to push money market rates upwards by several percentage points.

More generally, the Fed needs to shift to a more transparent and systematic monetary policy framework. Its semiannual reports to Congress routinely include a useful set of benchmarks, including the Taylor Rule as well as a variant referred to as the “balanced approach” rule. Federal Reserve officials should start explaining their plans in terms of such benchmarks, and they need to act very promptly to avoid repeating the costly mistakes of the Great Inflation.

Andrew Levin is a professor of economics at Dartmouth College. He previously served as a special adviser on monetary policy strategy and communication at the Federal Reserve Board.