Average inflation has risen to the Federal Reserve’s 2 percent target. Consumer prices grew at an annual pace of 7.5 percent in April and by 3.6 percent over the past 12 months, according to the Fed’s preferred measure. As a result, despite a decade of disinflation, inflation has averaged 1.9 percent to 2.0 percent over horizons between two and five years. Moreover, the Cleveland Fed projects that prices grew at an annual pace of 2.5 percent in May, and forecasts a similar pace for June. My advice ahead of the Fed’s June meeting: Don’t tighten your monetary policy until you can see the whites of your target’s eyes. But take aim, for inflation marches on our position at full pace.
The twin scourges of deflation and unemployment are old foes. In March 1933, during his first inaugural address, President Franklin Delano Roosevelt spoke of them as our “national emergency.” Consumer prices had fallen by over a third since the Great Depression began. Lower prices raised the burden of debtors, including farmers, and were of little solace to the 1 in 4 workers unemployed. To meet this crisis, Roosevelt demanded from Congress “broad Executive power to wage a war against the emergency, as great as the power that would be given to me if we were in fact invaded by a foreign foe.” He received it.
Roosevelt’s presidency fundamentally transformed our American system of government. In his words from the same address, “Our Constitution is so simple and practical that it is possible always to meet extraordinary needs by changes in emphasis and arrangement without loss of essential form.” And so, he did. Roosevelt removed our “golden fetters” by suspending the dollar’s convertibility into gold, abrogating contract clauses requiring payment in gold and forbidding the hoarding of gold. Roosevelt also reformed the banking system, instituted federal deposit insurance, and overhauled the Fed’s governance.
Economists of all stripes credit these actions with beginning the initial economic recovery, which lasted until May 1937. Notable among them is Milton Friedman, despite his staunch opposition to Roosevelt’s other New Deal policies. In his pathbreaking history of the Depression written with Anna Schwartz, they blame the inaction of the Fed for turning a series of banking panics into a full-blown global crisis. If money is the lifeblood of the economy, deflation is circulatory shock after an injury. Roosevelt’s actions were the keys to restarting circulation.
Following the Depression, the nation faced a different scourge: high and volatile inflation. Wartime borrowing spiked the U.S. debt burden to above 100 percent of gross domestic product. The Fed was unable to stabilize inflation because it was not politically independent from the U.S. Treasury at the time. For example, 12-month inflation exceeded 20 percent in March 1947. Ultimately, the Fed won its independence with the 1951 Treasury-Fed Accord. Despite the government’s debt burden, it broke the back of inflation by raising interest rates, and did so again in the 1970s and 1980s.
Since then, inflation and interest rates have substantially declined. Concerns of deflation re-emerged in the 1990s when Japan’s growth stalled after a financial crisis, and the Bank of Japan was seemingly unable to generate inflation. These concerns became ever-more salient for the United States and Europe with the global financial crisis, prompting the Fed to adopt an inflation target of 2 percent in January 2012. The thinking: low and stable inflation will ward off deflation. Yet, the Fed persistently undershot its target during the 2010s.
With the pandemic, we lurched to another national emergency. Unemployment spiked to nearly 15 percent in April 2020. Underemployment spiked to nearly 23 percent in the same month. In March and April, consumer prices fell at annual paces of 3.2 percent and 6.2 percent, respectively. Seeing the risks, the Fed met the crisis immediately and aggressively. Moreover, to rectify its prior disinflationary bias, the Fed adopted a policy of flexible average-inflation targeting in August 2020. In plain English, the Fed would make up for periods of undershooting by allowing for temporary overshooting. Policymakers have hit this average faster than they may have imagined.
Policymakers should stay the course and prove the credibility of their 2 percent target. Banish the deflationary specter haunting Europe and Japan from our shores. But continue to act in a data-dependent way. With the national debt again above 100 percent of GDP, plan for the possibility that inflation continues to soar, even while the labor market remains somewhat slack. You may need to tighten sooner than you think.
Christopher M. Russo is a research fellow with the Mercatus Center at George Mason University; prior to joining Mercatus, he advised top policymakers at the Federal Reserve on monetary policy and sovereign debt management.
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