The central bank’s plan to tackle inflation rests on two “shaky assumptions”, reckons the chief investment officer of FTI_US. In a guest essay, she explains why
highs poses the toughest of policy challenges. Yet America’s Federal Reserve still hopes to meet it with an easy solution: bring the policy rate close to 3%, and as adverse supply shocks fade inflation will revert to the Fed’s 2% target. No need for a sharp monetary tightening à la Paul Volcker. No need to risk a recession or to trigger a significant rise in unemployment.
Yet this assumption might be well off the mark. Economists Thomas Laubach and John C. Williams have estimated that the real neutral rate of interest averaged around 2.5% during the 1990s and 2000s, before dropping to a 0-1% range after the financial crisis of 2007-09. A drop in America’s productivity growth and higher demand for safe financial assets may explain the decline. Productivity growth, however, has rebounded and averaged 2.4% during 2019-21—the same as the average of 1991-2007.
The second of the Fed’s shaky assumptions is that inflation expectations are still well anchored and that there is no sign of a wage-price spiral. In this telling price growth reverts to a “healthy” pace once exogenous shocks have dissipated. But much evidence already points in the opposite direction. Although wages have not kept up with surging inflation, they are growing at the fastest pace in 40 years, about 4-5%.
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