Start with the job market. It is now tighter than at any time in history: the relationship between vacancies and unemployment is in unprecedented territory, resignations are at near-record levels, and wage growth is still rising to 6%, having accelerated rapidly in the past months. The FOMC expects further tightening, to an unemployment rate of 3.5%, which is expected to be maintained until 2024.
Three years with 3.5 percent unemployment, something the country hasn’t seen in about 60 years, is highly unlikely. Indeed, the historical experience is that when unemployment is below 4%, there is a 70% chance that unemployment will rise rapidly in the next couple of years as the economy goes into recession.
But this is not the central nonsense in the Fed’s predictions. The main problem is the idea that a super-tight labor market will somehow coincide with a rapid slowdown in inflation. Even based on the Fed’s upbeat accounting, a balanced economy requires 4% unemployment, which means it expects the labor market to remain abnormally tight over the next few years.
The data on vacancies and scarcity support the hypothesis that these conditions are inflationary, not disinflationary. Wages are by far the largest component of costs. When they are rising so fast, what basis is there for assuming that inflation will slow down to the Fed’s predicted 2 percent range?
Focusing on the rigidity of labor markets as the basis for forecasting inflation is firmly in the progressive Keynesian tradition. Many economists look, as Milton Friedman and Paul Volcker did, at measures of the money supply or projected public debt as a guide to inflation. These indicators are much more alarming.
A look at the Fed’s revisions to the forecasts since December reveals his confused thinking. The central principle of anti-inflationary monetary policy is that real rates must be raised to reduce inflation. Equally, interest rates need to be raised by more than mixed inflation and above a neutral level that neither accelerates nor slows growth. I had assumed this was universally accepted following the work of former George W. Bush administration official John Taylor and former President of the Obama Administration’s Council of Economic Advisers Christina Romer and her husband, David Romer.
However, due to upward revisions to inflation forecasts, the Fed’s projected real rates have actually declined in recent months. In other words, the FOMC plans don’t even require you to keep up with the growing inflationary gap. It is difficult to see how interest rates that even three years from now will be around 2 percentage points lower than current inflation rates can reasonably be considered sufficient containment.
Does all this matter as long as the Fed raises rates? Some will dismiss my concerns as technical quibbles. But according to what reasonable economic model does a rapid decline in inflation occur along with negative real interest rates and record low unemployment?
Perhaps the Fed still believes inflation is in fact transient and will evaporate as supply chains are restored. This never seemed plausible given accelerating residential and wage inflation and room for accelerating costs of healthcare, airfare and accommodation. It seems even less plausible today, with the war in Ukraine and covid blockades in Asia.
Or perhaps FOMC members are wary of pessimistic predictions. But why shouldn’t they realistically predict? It is a strange and harmful view of democratic accountability that requires false predictions from revered institutions. In a world where financial crises are always possible, the credibility of the Federal Reserve is a valuable asset. It shouldn’t be sacrificed lightly.
Our democracy is more threatened at home and abroad than ever in the past 75 years. Rampant populism is a product of inflation and distrust of the government. The Fed is outside of politics but not of our civic life. He has an obligation to show more intellectual rigor and honest realism than this week.