The pandemic has been the catalyst for a seismic shift in the American economy as it shifts from an era of abundance to one of insufficient supply.
For households, this implies a shift from what we call rational inattention regarding consumption to a more rational approach to spending.
As Federal Reserve Chairman Jerome Powell put it bluntly on Friday in his remarks at Jackson Hole, Wyo.: “Reducing inflation is likely to require a sustained period of below-trend growth.”
Central bankers across the globe are being guided by three lessons from the inflation of the 1970s and 1980s.
First and foremost is that it is the central bank’s responsibility to reduce inflation.
Second, the public’s expectations about future inflation can play an important role in setting the path of inflation over time. Powell said that by many measures, longer-term inflation expectations appear to remain well anchored for now.
The third lesson—and in our view the most important message from the address—is that central banks must keep at it until the job is done.
As Powell stressed, the employment costs of bringing down inflation are likely to increase if there is a delay. For this reason, another 75 basis-point increase in the Fed’s policy rate at its meeting next month is a distinct possibility.
We agree with Powell that slower growth, and softer labor market conditions will reduce inflation, which will bring pain to households and businesses. These are the unfortunate costs of reducing inflation. Yet a failure to restore price stability would mean far greater pain.
We also agree with Powell’s view that the current high inflation in the United States is the product of strong demand and constrained supply coming out of the pandemic.
Because the Fed’s tools work principally on aggregate demand, if there is to be relief for households, it must come from Congress.
It is our view that there will be a multiyear transition from relying on the abundance of cheap goods from Asia and the dependence on energy controlled by geopolitical adversaries.
That change implies recognition of a higher equilibrium rate of inflation on the order of 3% to 4%.
Because that transition also assumes a higher cost of capital, then maintaining adequate levels of economic growth implies rational fiscal policies promoting investment in essential sectors that most affect inflation. These include energy, housing, the supply chain and food.
