Joe Biden will unveil details about his infrastructure plan today. This plan is expected to be a four-part, eight-year plan totaling around $2 trillion dollars and include a corporate tax hike to 28% from 21% and a 21% minimum tax to be set on global corporate earnings. The plan is expected to allocate $620 billion for transportation, $650 billion for initiatives related to improving quality of life at home and $580 billion for strengthening American manufacturing. The combination of easy monetary policy (rates pinned near zero) and loose fiscal policy (nearly $3 trillion over the past three months, excluding infrastructure spending) seen over the past year has pushed up growth and inflation expectations and raised the question of what happens when the Fed meets its goals.
Over the next two years, things are pretty clear. The Fed wants to overshoot both its 2% inflation target and its estimate of full employment. On the path to these objectives, the Fed also hopes to create a hot enough job market to benefit disadvantaged workers.
Strategically, the Fed not only would want to quickly achieve its goals but would also want to only react to hard evidence of success and not forecasted success. As such, the Fed will aim to delay tapering bond purchases as long as possible and will keep the funds rate pinned to the floor through at least 2023, even if there is a small overshoot of the inflation and employment targets.
However, there has been much less discussion around the end game. Thus far, the message has been something along the lines of, “Don’t worry, we have the tools to stop the acceleration.” Because there is no limit on how high the Fed can raise rates, it’s hard to argue that the Fed lacks the tools to stop inflation once it gets going.
Unfortunately, it’s not as simple as just raising rates. Empirical data shows that the unemployment rate has never risen more than 0.5% without a recession occurring. This means that the Fed’s attempt to cool inflation through slower growth and a modest rise in unemployment is a tricky path to navigate, as illustrated by numerous recessions triggered, in part, by the Fed fighting inflation and hiking rates.
But there are examples of when the Fed hiked rates, in part due to inflation concerns, yet the economic recovery continued. Here’s a review of these episodes: - 1967: Core CPI inflation started to surge in May 1966 due to easy fiscal and monetary policy and a falling unemployment rate. The Fed tightened policy, triggering a recession in the housing industry. As a result, the Fed backed off. But with inflation still on the rise, the Fed eventually continued its rate hikes enough to trigger the 1970 recession.
- 1984: Inflation measures spiked up partly because housing costs were measured using mortgage costs. The Fed responded by hitting the brakes but backed off once it became clear that inflation was temporary.
- 1994: This is the most popular soft-landing scenario. In 1994 the Fed became concerned that a strong labor market would trigger inflation. It repeatedly hiked rates, but the strong labor market continued. Because of explosive inflation in the 1970s, the Fed assumed a non-accelerating inflation rate of unemployment (NAIRU) that was higher than actual unemployment. As such, the Fed continued its hiking cycle until 1995 when the economy started to slow. Ultimately, feared inflation never materialized. With the benefit of hindsight, we now know two things saved the economy from inflationary pressures. The first is that the Fed assumed a NAIRU that was too high. The second is that 1995 marked the start of a decade-long boom in productivity growth. High and sustained productivity gains offset the rise in wages, allowing companies to keep pricing moderate.
The question now is, what happens in 2023? Does the Fed get lucky like it did in 1995? Does it accept higher inflation as in the late 1960s? Does it wait too long and trigger a recession to avoid too-high inflation, or does it switch gears before inflation becomes an issue?
Eventually, the Fed will have to switch to a more normal policy of reacting to the changing outlook. For now, the Fed message is that rate hikes are nowhere in sight, but if and when inflation moves toward the Fed’s goals, its message can change quickly. | |
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