DANIEL VAUGHAN: Federal Reserve finally attacks inflation. Is it too late?

After a year of dithering, the Federal Reserve finally arrived to the inflation partyThe Fed decided to raise interest rates by a quarter of a percentage point as an opening salvo to bring inflation under control. Now the million, or billion-dollar question: will it work?

The Fed said that many elements factored into their analysis. “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals. The Committee’s assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”

That list includes many things, and it’s understandable. Raising rates is risky business, but the Fed’s decision involves raising rates into an economic maelstrom. For all the talk of the strength of the American economy, the tailwinds are equally prominent. 

Triggering a recession?

Remember, raising interest rates is about attempting to slow or kill the demand side of the economy. Inflation is generally caused by too much demand and insufficient supply, causing prices to rise. The factors that cause the rise can vary greatly, but the basic equation is the same.

The underlying threat in slowing down demand is triggering a recession.

Both the White House and the Fed believe that this can go down without a recession. Gabriel Chodorow-Reich, an associate professor of economics at Harvard, called this belief “immaculate disinflation.” While it’s possible inflation goes down with no pain, there’s also the potential for a painful recession.

It’s not the first time the Federal Reserve got presented with the issue of inflation. Former Fed head Paul Volker used high interest rates to crash demand. Volker got ample support from President Ronald Reagan, who focused on boosting the supply side. Their plan worked, inflation got halted in its tracks.

The pain was real, too: Volker’s plan triggered a double-dip recession over two years. Reagan spent the rest of his two terms unleashing the American economy to dig out of the holes from the stagflation era of the 1970s.

Inflation has been here for a while.

The question for Jerome Powell, Joe Biden, and the modern Fed is this: how serious are they about stopping inflation? Biden’s one-liners that blame Putin for inflation are cute but wildly inaccurate. Former Obama administration economic officials Steve Rattner and Lawrence Summers have blasted Biden for claiming the Putin line while ignoring inflation.

If you’ve lived in America for the last year, you’ve experienced inflation. I’ve written about it, quoted Lawrence Summers on it, and the evidence on inflation has been clear for a while. The White House and the Federal Reserve have been claiming things like “transitory” or “short term.”

After a year, the Federal Reserve finally admits inflation is a serious problem. Their statement said, “Inflation remains elevated, reflecting supply and demand imbalances related to the pandemic, higher energy prices, and broader price pressures.” That last part, “broader price pressures,” is critical. Those words are an admission that inflation isn’t transitory and isn’t going away.

Tim Carney had the same analysis in his column. “While it is not unimaginable that inflation could largely fall on its own, the Fed has not clearly articulated a theory about why it expects this to happen. Is it expecting an imminent loosening of supply constraints? Does it think energy prices will plunge soon? Or something else? It would probably help if the Fed let us in on the source of its faith.”

What are the next steps?

We don’t know how or why the Fed believes inflation will fall by itself. Their belief in falling inflation is identical in statements to using terms like “transitory.” It’s hard to believe anything will happen automatically in this environment.

Consider the following. The Fed is raising rates in the middle of a land war in Europe involving Russia. Massive sanctions against Russia have ensued, and counter-sanctions are getting levied too. On top of the war, commodity prices are wild: oil is spiking, food shortages persist, and consumers are experiencing undersupply and high prices everywhere. The pandemic is still waning, China is engaging in lockdowns, and there’s an election at the end of the year.

That last part is essential to remember. Economic conditions are already bad for Democrats; adding a recession worsens their electoral odds. The White House needs the Fed to attack inflation but not strike it so hard to trigger a recession.

Is that even possible? No one knows. But the Fed is trying to have its cake and eat it too on inflation. Reality may tell us another thing: either you deal with inflation or avoid a recession and let inflation run hot. If the Fed tries to do both, it can fail at both.

If that happens, the failure rests on the White House while we bear its brunt.