Meteorologists tell us that global warming has created new problems for forecasters. Hurricanes are not only getting stronger, they are intensifying faster than ever before, making it difficult to warn communities in advance of their path. In particular, authorities in Lee County, Florida, waited for definitive evidence that Hurricane Ian was going to hit them hard before ordering an evacuation, and by then it was too late for many.
Is something similar happening with economic policy? I recently wrote about the growing buzz among economists and businesspeople that the Federal Reserve, which has been trying to slow down the economy to fight inflation, is hitting the brakes too hard. Since then, the rumors have intensified. And I am increasingly convinced that, despite the disappointing inflation report and what still looks, by some measures, like a strong labor market, the Fed is falling behind. I would say now that we are starting to see the effects of the interest rate hikes that the Federal Reserve has been making since the beginning of this year. No matter what the data on inflation and employment say right now; There is already a large reduction in inflationary pressures underway, as well as a large drag on production and employment. As some business analysts like to say, the economy could be “turning around.” And the risks that a strong currency policy poses to financial stability and the global economy in general are increasing.
Part of the problem is that the Fed hasn’t done for a long time, actually since the early 1980s, what it is doing now: tighten monetary policy to fight inflation. And some analysts may have forgotten an important lesson from the monetary policy of the old days; namely, that a considerable period must elapse before higher interest rates translate into an economic slowdown or a decrease in the rate of inflation.
Let’s think about how Federal Reserve policy affects the real economy. One of the main channels is housing. The increase in rates causes a reduction in the demand for houses, which leads to a drop in construction; As income from home construction declines, demand for other goods declines, with consequences rippling through the economy as a whole. But all this takes time. Indeed, the Federal Reserve’s rate hikes have caused a sharp drop in applications for building permits. However, construction employment hasn’t even started to decline yet, presumably because many workers are still busy finishing houses they started when rates were lower.
The other main channel through which the Federal Reserve affects the economy is through the value of the dollar. A strong dollar makes US products less competitive in world markets; the fall in exports and the increase in imports will end up being a major economic drag. But it takes time to switch to new providers, so we won’t really notice its impact until next year.
In short, current inflation and employment basically tell us about the past; we must analyze other data to glimpse the future. For example, a new report shows that unfilled job openings fell sharply in August. Why is this information important? Many economists, especially those who have been warning of the persistence of inflation, maintain that the rigidity of the labor market is better measured by the relationship between job offers and unemployment than by the unemployment rate itself. But this proportion, although still high, has already dropped considerably; as Goldman Sachs points out, nearly half the gap between jobs and workers has been closed in recent months.
Another new report shows that demand for flats has stagnated, which will eventually translate into slower rental growth, which is essentially what drives official estimates of the cost of housing, a key component of most measures of core inflation. Another thing: remember all those supply chain problems that disrupted the economy and pushed up inflation a few months ago? Well, the cost of shipping a container across the Pacific, which was $20,586 in September 2021, is now $2,265.
I would argue that these indicators tell us that the Federal Reserve has already done enough to ensure a decline in inflation, but also, quite possibly, a recession. Am I completely sure of what I say? Of course not. But monetary policy always involves risk compensation. And the risk that the Fed is doing too little appears to be rapidly diminishing, while the risk that it is doing too much is rising.
And add the risk of a financial crisis. The recent turmoil in the UK bond market was domestic in origin, but it may still be a harbinger of possible chaos stemming from rapidly rising interest rates. We don’t want the financial markets to dictate the Federal Reserve’s policy, but that doesn’t mean the Federal Reserve should ignore financial dangers.
We don’t want the Federal Reserve doing what Lee County did and refusing to act on warnings of an economic storm until all the uncertainty is gone.
