The risk of 1970s-style inflation is emerging, former Fed adviser says.
The Federal Reserve must keep playing catch-up with inflation and a benchmark rate of at least 5% is needed to keep things from getting out of control, former Fed visiting scholar Michael Bordo told MNI.
The Fed has a long track record of being slow to tighten and the fed funds rate may need to climb even higher than 5% to restore price stability, he said in a phone interview. While a recession is likely, that pain should be mild in comparison with the prospect of 1970s-style inflation returning, he said.
“If the Fed doesn’t follow through, raise the policy rate above the rate of inflation, or the rate of expected inflation, if they don’t have a positive real interest rate, inflation will not be licked. I feel very strongly on that,” Bordo said.
“A lot of Fed officials now are talking about raising rates to 4, 4.5. The number I always had in mind was 5, if they raise to 5, or 5.5, that would do it,” he said.
GOING TO BE SLOPPY
The FOMC isn't currently seen as being that aggressive. Policymakers update their views in a decision Wednesday where the "dot plots" may call for the key rate to reach at least 4% by yearend with a peak around 4.5% in 2023, former officials and staffers have told MNI. Markets expect the rate to increase another 75bps to 3%-3.25% this week. (See: MNI: Fed Sept Projections To Show Higher Rate, Inflation Peaks)
Debate over how much to hike centers around views the Fed is overdoing it and causing a painful recession. (See: MNI INTERVIEW-Fed’s Anti-Inflation Drive Risks Overtightening) The U.S. economy is already likely tipping into a recession because of the delayed response to inflation, Bordo said, but it would also be very surprising if the Fed managed any kind of soft landing from here.
“It’s going to be sloppy because the economy is going to be hit,” he said.
More alarming are labor disputes like the one that almost ended in a railway workers' strike, and calls for major wage increases, an echo of the 1970s, Bordo said. While today's economy isn't burdened by wage-price controls, a weak U.S. dollar or a Fed that looks the other way when inflation climbs, he said the threat of un-anchored prices is real.
“Once people realize that prices are not going to fall, they are going up, their real incomes are going down, if they have any ability to raise wages and use the unions that they have they are going to do it,” he said.
HAVE TO STAND TOUGH
“The risk to me right now isn’t that the Fed tightens too much, the risk is that they don’t tighten enough. The chances are pretty good they won’t get it right and we will have a recession, the real question is how bad it’s going to be.”
The Rutgers University professor recently co-authored a paper with Mickey Levy reviewing economic cycles back to the years following World War I, finding policymakers were slow to tighten a majority of the time and the result was often a recession. The Fed has never been so far behind the curve in as in this cycle, partly because of the recent shift to average inflation targeting and a focus on pushing for full employment, Bordo argues.
The Fed could improve by shifting towards rule-based policymaking and more pre-emptive action in the style of Alan Greenspan and Paul Volcker, he said. Fed officials need a longer-term view to guard against pressure to slack off as the prices of high-profile items like gasoline recede and politicians hear complaints about job losses, Bordo said.
“They have to make that case, and they have to stand tough,” he said.