Even a Recession Might Not Tame Inflation

The market has spoken: It’s expected that the Federal Reserve’s fight against inflation is just about over. Fed Chairman Jay Powell has hinted that rate increases are nearly at an end. But inflation was still at 6% last count, and Powell insists the Fed is still committed to reaching its 2% target.

He may be thinking — along with some other economists — that the Fed has already done enough. After all, interest-rate increases can take a few years to ripple through the economy and lower inflation. The current banking turmoil could be the first sign of that starting to work. Forecasters have swung away from a soft landing for the economy and are again predicting an imminent recession, which should put the final nails in inflation’s coffin.

Unfortunately, we can’t count on a recession to solve our inflation problem. Odds are, the Fed still has more work to do if it’s serious about getting inflation back to 2%.

How monetary policy affects the economy and inflation is not that well understood. Tighter Fed policy reduces the money supply, which is presumed to lower inflation just because there is less money sloshing around. But as former New York Fed President Bill Dudley explained, after the Fed started paying interest on the bank reserves it holds, the money supply became less important because it severed the relationship between the money supply and credit.

Nonetheless, a higher policy rate is presumed to contract the economy because it makes credit scarcer and more expensive. This means less investment, more failing firms, fewer people buying or building homes, and ultimately higher unemployment. At this stage workers get smaller raises, if they get them at all, and people are generally more pessimistic and spend less. Hence, demand falls and brings down inflation. Or so the thinking goes.