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Tuesday, August 16, 2022

Inflation targets and fed interest rate increases could backfire

As of this week, inflation is at 9.1% — the highest in over 40 years and well above the Federal Reserve Board of Governors’ target of 2%. As interest rates inevitably increase in response, predictions of a recession are only growing.

Yet, by many measures, the economy is also strong. The recovery from the recession brought on by the coronavirus pandemic was remarkably rapid, nearing full recovery in the labor market in just over two years. Compare this to the eight years it took America to recover from the Great Recession. What’s more, and for the first time in six decades, wage inequality is declining, and by at least some metrics, racial divides in labor market outcomes are narrowing. Unfortunately, if the Federal Reserve continues to aggressively raise interest rates to achieve its target inflation rate, it is likely to put the brakes on a labor market that is starting to deliver real gains for workers — and this could make the wallets of middle- and lower-income Americans even tighter.

Gas prices are the highest they have ever been in my lifetime, and food costs have risen a shocking 10.4% over the last 12 months.

Indeed, gas prices are the highest they have ever been in my lifetime, and food costs have risen a shocking 10.4% over the last 12 months. These two expenses have huge impacts on the average consumer; however, it’s important to keep in mind that these are also volatilely priced items. As a result, economists often look to the rate of inflation, minus food and energy costs, to get a sense of broad-based inflation — in other words, to understand what inflation looks like without distortionary items factored in. At 5.9% over the last year, this figure is higher than anyone would like to see it, but it’s still notably lower than the overall rate of inflation. This implies that the broader picture of who loses and who gains from continuing to increase interest rates is more complicated and that because of this, it may be time to reconsider how monetary policy interplays with the 40-year rise in economic inequality.

The history of that hallowed 2% inflation rate isn’t particularly long. This figure, which is now a global economic convention, was pioneered by New Zealand; in the early 1990s, the small country established a formal goal to rein in price volatility and prove it was serious about tempering the high inflation rates that had been hurting many economies since the 1970s. Countries like the U.S. followed New Zealand’s example — beginning in the mid-1990s, the Federal Reserve began pursuing an implicit 2% target before it officially adopted it in January 2012. As of today, central banks around the world also have this target inflation rate.

However, the 2% target has different implications for different groups. Very high rates of inflation hurt the families who spend more of their incomes on consumption — the daily costs of living — than they do on saving or investing, pinching their budgets and limiting their spending power. But very low inflation also has lopsided benefits for asset holders — those with financial investments and stock holdings, whose wealth (and what others may owe them) maintains its value. Between these two levels is moderate inflation that benefits debt holders, whose liabilities decrease in value as inflation reduces the real value of what they owe. In this way, moderate inflation could essentially help redirect the vast flow of wealth from wealthier, older households toward younger, middle-class households.

But what exactly is a moderate inflation target? In one hypothetical estimation, inflation in the range of 5% would redistribute wealth from households in the top 10% of the wealth distribution to middle-class households under age 45, which would essentially receive a bonus of up to 45% of their net worth through reduced debt. Importantly, the government would also benefit — inflation of 5% would reduce the real value of government debt in the range of 5.2% to 13.0% of gross domestic product.

Still, you may hear economic commentators refer to the risks of “overheating” the economy, leading to an upward spiral of costs and prices. But not only is there no evidence of a wage-price spiral in the current economy; the connection between a low target inflation rate and healthy economic growth is also tenuous, at best. In a cross-country comparison of various inflation rates and economic outcomes from 1961 to 2000, economists Robert Pollin at the University of Massachusetts Amherst and Andong Zhu at Tsinghua University in Beijing found that real GDP can continue to have moderate growth even as inflation reaches a threshold of 15% or so.

And as the Federal Reserve attempts to dampen demand to reduce inflation, the lower demand for workers harms those facing more barriers to opportunity in the labor market. While the ratio of the unemployment rate of Black workers to white workers is unacceptably high at 1.75 to 1, it is the lowest this divide has been in decades. And there is evidence that interest rate increases hurt the employment rate of Black workers more than they hurt white workers. All we can achieve a 2% inflation target that primarily benefits the wealthy.

Of course, this isn’t to diminish the real impact of inflation on family budgets, as prices remain high and wage growth begins to cool down. But interest rates aren’t the only tool we can use to ease the burden — lawmakers also need to implement policies that target the specific causes of where we are seeing the strongest inflation. Reducing reliance on gas, ensuring all families have access to high-quality, affordable food and funding our weak social infrastructure in ways that mitigate long-term rising costs for things like child care and health care would do more to help everyday Americans than continuing to merely funnel wealth to the top. By doing so, we would also make a much-needed investment in protecting households against the next inflation cycle, and that would go a long way toward fostering economic growth that is stronger, more stable and broadly shared by future generations.


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