About the author: Josh Bivens is the director of research at the Economic Policy Institute.
It has become conventional wisdom in recent months that the Federal Reserve must “cause pain” to get inflation back to more-normal levels. What is meant by causing pain is pretty clear—the Fed raising interest rates high enough to cause unemployment to rise significantly. This impression that pain is necessary hasn’t come from out of the blue. Influential commenters have made an affirmative case that unemployment must rise sharply to normalize inflation.
This is nonsense. The inflation of the past two years was largely the result of global shocks. It was damaging but largely inevitable. The strong labor market over this time didn’t amplify this inflation; instead it mostly helped to protect American families from its effects. As the shocks ease, we don’t need more pain even for the too-formalistic goal of returning inflation to the Fed’s official 2% target.
More broadly, shouldn’t the goal of economic policy be to avoid pain?
The timing of the rise of the pain caucus is especially perverse. The campaign of interest-rate increases to rein in inflation only began in March. The Fed has ratcheted up rates several times since then, and it takes time for those increases to slow the economy’s growth. Those dynamics mean less than half of the full effect of these increases has come to pass so far. And yet overall inflation is decelerating; price inflation for housing in the consumer price index, the index’s single most-important component, is dead-certain to begin decelerating rapidly in 2023; and the labor market is potentially weakening.
We have had two very good data releases in a row on CPI, the most popular gauge of inflation. The inflation rate for “core” prices (excluding volatile food and energy prices) ran at a 2.4% annualized rate in November, according to the latest data, down from peak rates of well over 7% earlier this year. This is a substantial deceleration.
Most of the remaining core inflation in the latest CPI report was in housing costs. But real-time industry data has shown unambiguous signs of rapid cooling in housing and rental markets, and reams of research indicates that these more-timely industry data are reliably mirrored in CPI data with a 6-12 month lag. In short, disinflation in housing costs is clearly in the pipeline already and will add downward pressure on prices soon.
Finally, the very strong labor market has begun slowing, and there are some signals (noisy and uncertain for now) of worrying weakness. For example, the share of all adults aged 25-54 with a job improved dramatically between January 2021 and August 2022, but has only ticked down since then. Other signs continue to point to a strong labor market, but at least some cracks are showing.
Many have argued that the labor market is generating too-fast wage growth to keep inflation in check, justifying the need for pain on those grounds. It’s true that the level of wage growth in recent months is higher than would be consistent with the Fed’s 2% inflation target, but this wage growth clearly peaked much earlier in 2022 and is heading back down. This peak occurred well before more-recent signs of labor market cooling, so it seems clear that wage growth can normalize even in the face of low unemployment rates. That is, we didn’t need pain to see a large deceleration of nominal wage growth in the middle of this year, so, why are we so sure we need it going forward?
But let’s step back for a second from the nitty-gritty about wage and price trends consistent with getting back to the Fed’s 2% inflation target. Shouldn’t economic policy always aim to avoid pain? Arguing that the Fed must inflict pain to get inflation under control would only make sense if the pain of today’s inflation were worse than the pain of higher unemployment to come. That’s not even close to true. Recessions cause far more distress than the kind of inflation we’re now experiencing—and this was obvious even before the signs of pronounced inflation decelerations in recent months.
Many have noted that inflation-adjusted (real) wages for most American workers fell in most months since 2021 as inflation outpaced wage growth. These falling real wages are then used as a justification for claiming today’s inflation is causing harm. It’s true that today’s inflation is inflicting harm on workers, but engineering a recession with higher interest rates would just make this worse. Higher unemployment doesn’t just restrain inflation, it also reduces nominal wage growth—and by a lot more. In short, real wages will fall faster if unemployment rises.
All in all, there is no compelling case that American families would be better-off if the Fed damaged the job market in the name of fighting inflation. Yes, higher unemployment would pull down inflation even faster than it is currently falling, but only at the expense of millions of jobs and slower wage growth for tens of millions. The gain wouldn’t be worth the pain.
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