How Far Will the Fed Have to Go to Tame Inflation?

Ordinary reality doesn’t change depending on whether you believe in it or not, as Neil deGrasse Tyson, the astrophysicist and science educator, likes to observe. But ordinary reality isn’t the world central bankers live in. They live in a world of self-fulfilling expectations. We saw that this week when Jerome Powell, the chair of the Federal Reserve, addressed reporters at a news conference on Wednesday.

Powell said forcefully that the Fed will lower inflation to its target of 2 percent “in time,” and that it should be able to do so without throwing a lot of people out of work.

If people believe Powell, he will be correct. Confident that inflation will subside, companies won’t raise prices rapidly and workers won’t accelerate their wage demands.

But if people don’t believe Powell, he will be wrong. Inflation will stay hot, and to lower it the Fed will have to plunge the economy into a fairly deep recession. It will have to use its bazooka instead of just brandishing it. Unfortunate.

That’s why credibility is essential. Central banks have no control over causes of inflation such as energy prices, de-globalization and workers’ detachment from the labor force. But central bankers can control how they talk and act so people believe them when they promise that lower inflation lies ahead.

A high-achieving, credible central bank will enjoy a low “sacrifice ratio,” which is a measure of how much economic growth it has to sacrifice to reduce inflation. A ratio of 2 means cumulative output over time has to decline by the equivalent of 2 percent of one year’s economic output to lower the inflation rate by 1 percentage point.

In a perfect world, where the central bank practices optimal policy and everyone trusts it to do so, the sacrifice ratio can be as low as 0.5 or so over a five-year window, according to a staff working paper last year by Robert Tetlow, a senior adviser in the Fed’s Division of Monetary Affairs. At the other extreme, if the Fed isn’t trusted, the ratio could be roughly 20 to 30, Tetlow found, based on simulations using the Fed’s main forecasting model.

Gradualists argue that the Fed shouldn’t be in a hurry to get inflation back to target. Alan Blinder, a former vice chair of the Fed, wrote in The Wall Street Journal in September that drastic action isn’t justified because inflation expectations remain low — in other words, the Fed’s credibility remains strong. “Today’s inflation is still a youngster,” he wrote.

Others prefer to go cold turkey. Last year James Bullard, the president of the Federal Reserve Bank of St. Louis, argued that “front-loading” interest rate increases — the opposite of gradualism — will inflict less pain in the long run because it will cause people to lower their inflation expectations faster and behave accordingly.

Joseph Brusuelas is pessimistic. According to his estimates, getting inflation down to 2 percent would require the unemployment rate to rise to 7.3 percent, causing 6.1 million job losses, Brusuelas, who is the chief economist of RSM US, a tax, audit and consulting company for midsize companies, wrote in a blog post last week with a colleague, Tuan Nguyen.

One reason it’s getting harder for the Fed to reach its 2 percent inflation target is that inflation expectations have drifted upward, albeit not drastically, Brusuelas and Nguyen wrote. Also complicating the Fed’s job, they added, are the partial uncoupling of the U.S. economy from China’s and slow labor force growth.

Fewer jobs — about 2.5 million — would be lost if the Fed settled for getting inflation down to 3 percent, they wrote. That’s what they think the Fed will in fact do: set a de facto target for inflation of 3 percent rather than the stated 2 percent.

The Federal Reserve’s policymakers, in the Survey of Economic Projections released on Wednesday, have a much rosier view. The median projections in the survey are for inflation to fall to 2.1 percent by 2025, just a hair above target, and for unemployment to average 4.6 percent next year and in 2025, not far above the long-run sustainable rate of 4 percent. In the paper that Tetlow put out in November, when the Fed’s projections were roughly similar, he wrote that the sacrifice ratio implicit in the projections was “a little on the low side, by most standards, but is within the plausible bounds.”

Fed policymakers have an incentive to express confidence, as I mentioned above. For independent takes I went to two prominent Wall Street economists. Michael Gapen, the head of U.S. economics at Bank of America, told me the bank’s forecasters see inflation getting down to 2 percent even sooner than the Fed policymakers do — although that’s because they predict a mild recession starting later this year, which the Fed people aren’t predicting.

It’s possible that getting down to 2 percent inflation will be unexpectedly costly in terms of job losses, but the only way for the Fed to find out is to keep pushing and see what happens, Gapen said.

Jan Hatzius, the chief economist of Goldman Sachs, told me he believes it probably won’t take a recession to get inflation down to roughly 2.5 percent, a rate he thinks would be within the Fed’s comfort zone. All it will take, in his forecast, is for the economy to grow at a below-trend pace for a while longer while the share of people working or looking for jobs edges higher.

The Readers Write

Regarding your newsletter on ideas for preventing bank failures: Perhaps the very best service The New York Times could provide is the tracking of management and board personnel of failed banks. Any company hiring them should go on the paper’s watch list.

Dennis Merens
Peoria, Ariz.

I disagree with insuring all deposits. That would trigger substantial premium increases by the Federal Deposit Insurance Corp. Those expenses would fall equally on all customers in the form of higher loan rates and lower deposit rates. Small depositors would be subsidizing large depositors like Peter Thiel.The best remedy for bank failures is to reinstate the Glass-Steagall Act, which separated commercial banking from investment banking.

Orin Hollander
Jamison, Penn.

Replicate Canada. We were the only O.E.C.D. country to not have to bail out a bank in 2008-2009 and have not had a material bank failure for 100 years. Three financial ratios (and deafness to lobbying for change in them) and a single national regulator … and bingo bongo you’re done. Next problem.

Bill Stewart
Delta, B.C.

I have yet to see any comments on those of us, probably in the millions, who have Treasury bonds in their retirement accounts, and how much their value has declined in the last year. Do we get bailed out?

Ian A. Crossley
Brixham, England

Regarding your quote from E.O. Wilson about human impact on the environment, other species have changed climate just by being alive, but they have done so on a geological time scale. What’s extraordinary about our species is that what we like to call intelligence is making these changes happen many orders of magnitude faster. In short, we are screwed.

Daniel Coren
Philadelphia

Quote of the Day

“This is the problem of error-blindness. Whatever falsehoods each of us currently believes are necessarily invisible to us. Think about the telling fact that error literally doesn’t exist in the first person present tense: the sentence ‘I am wrong’ describes a logical impossibility.”

— Kathryn Schulz, “Being Wrong: Adventures in the Margin of Error” (2010)