The Federal Reserve is widely expected to hold interest rates steady at its meeting today, trying to achieve the fabled “soft landing” that has been one of its goals since Paul Volcker’s tenure as chairman 40 years ago. At the same time, it is turning its back on the experimental spirit that made Volcker a legend.
Volcker, who died Sunday, came to the Fed at a time when inflation was rampant. The conventional wisdom then suggested that addressing inflation head-on through monetary policy would be too difficult. The economist James Tobin warned at the time that it might require a seven-year-long recession to bring down the rate of inflation. There was also widespread confusion about how interest rates, which rose from 4.5% in 1977 to 13.5% in 1979, were affecting the economy. To outside observers, it seemed as if the increase was having no effect. What they failed to account for was that inflation expectations had been rising even faster.
There were even suggestions that, in an economy dominated by large corporations and unions, the Fed could not realistically control inflation. Some economists argued that traditional economic theories which made sense in a world of small competitive firms were not useful in an economy as large and complex as America’s.
The lesson that the Fed took away was twofold. First, that managing runaway inflation was unquestionably its responsibility. Second, that if inflation got out of hand, it would have to act quickly and risk a recession.
From that arose the Fed’s obsession with creating a so-called soft landing: Whenever the economy began to heat up and rising inflation seemed imminent, the Fed would begin to slowly raise interest rates. That was the logic behind the Fed’s decision to begin raising interest rates in late 2015, pausing when a mini-recession hit, and then resuming its hikes in 2016. By December 2018, the Fed had raised interest rates eight times.
That cycle turned out to be a mistake. The U.S. economy started flashing recession signals in early 2019, forcing the Fed to reverse course and cut rates three times. Now, after a good job report last week, it seems that it may have achieved the soft landing it was looking for — thus fulfilling Volcker’s legacy.
In another way, however, it is abandoning it. Forty years ago, economists failed to account for rising expectations of inflation. Now they are so afraid of inflation that it is blinding them to common-sense economic analysis. The economy may be in the midst of a record expansion, but there is ample evidence that the job market could be even better. Meanwhile, inflation seems to be inching downward, and expectations suggest that it will fall still more.
To truly fulfill Volcker’s legacy the Fed needs to throw off the old consensus and continue to cut rates. Unemployment may be low, but the percentage of the U.S. population that is working lags behind its peers in the developed world. Too many Americans have simply given up or aren’t quite sure how to make their way back into the labor market.
A strong economy has drawn some of those workers back, but an even stronger economy would attract even more. Aggressively cutting rates would risk sparking a little rise in inflation — but as Fed Chairman Jerome Powell has recognized, low inflation is a more pressing concern than high inflation.
What is missing is some of the gumption Volcker displayed when he plowed through the late-1970s economic consensus. If Powell were to show that today, and keep cutting rates, he could strengthen the American labor force and claim his own place in Fed history.
(This column does not necessarily reflect the opinion of economictimes.com, Bloomberg LP and its owners)
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