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What If the Fed Just Lets Inflation Run for a While?

At this point in the economic cycle, monetary policy is a waiting game. The Federal Reserve believes it has met its mandate of full employment. Inflation is just about at its target. The central bank’s plan, as my colleague Tim Duy has discussed, is to raise interest rates quarterly until back to roughly the Fed’s estimate of neutral policy. Once policy is back to neutral, officials will be looking for signs of inflation overheating, at which point they’d likely tighten policy past neutral, restricting and perhaps ending the growth phase of this economic cycle.

But while this strategy would succeed in cooling off any overheating the economy may experience over the next several quarters, it would fail to address the emerging challenges that higher prices would reveal. Inflation resulting from supply bottlenecks like we’re starting to see is very different from inflation resulting from excess investment like we’ve seen in the past. If the Fed is willing to see it, there is plenty of evidence now that inflation targeting itself is a misleading objective for monetary policy.

While we don’t yet know if we’re going to experience inflation significantly above the Fed’s 2 percent target over the next few years, if we do, we can be fairly confident in why it would occur. We’re seeing signs of it in 2018. A shortage of truck drivers leading to a spike in freight rates. A shortage of construction workers and tight zoning regulations in urban areas leads to higher construction and housing costs. A tariff war leads to higher prices on raw materials. At first producers eat these higher costs, squeezing profit margins, but eventually they are passed on to consumers in the form of higher prices.

When it comes to Fed orthodoxy, the combination of full employment and above-trend inflation leads to an inarguable conclusion: raise interest rates until the economy cools off. But while in prior cycles this may have addressed some of the issues plaguing the economy at the time – excess telecom investment and dot-com speculation in the late 1990s, excess housing investment and credit creation in the mid 2000s – in this cycle that’s not the case. Rather than reducing excess investment, the Fed would be doing something akin to demand rationing in a supply-constrained economy, like ridesharing companies implementing surge pricing on New Year’s Eve to crush demand.

But raising interest rates across the whole economy to address a truck driver shortage doesn’t make sense. Instead, we should come up with policies and incentives to increase the supply of truck drivers and construction workers. Like higher wages brought about by a labor shortage.

The Fed needs a more flexible approach to inflation. Rather than a rigid view that 2 percent is some magical target, it should be more aggressive when there are signs of excess investment or speculation in the economy, and back off when the inflation is the result of supply bottlenecks in core parts of the economy.

A recent historical example of this dynamic in practice would be oil prices over the past 15 years. In the 2000s we saw a large run-up in the price of crude oil. After prices had been rising for several years, fears emerged that we would hit “peak oil” at which point supply shortages and high prices would crush the economy. But those higher prices led to investments in oil production and alternatives. While the price of oil spent six years around or above $100 a barrel, markets eventually worked in alleviating the shortages and lowering prices by increasing supply.

Rather than using monetary policy, we should allow a similar solution to unfold for trucking and the construction industry. If higher freight prices allow truck drivers to earn $100,000 per year for a sustained period, expect some combination of more workers coming into the industry and productivity gains, perhaps through automation technologies like self-driving trucks. Higher construction and housing prices are likely to have a similar effect on construction labor, as well as perhaps putting pressure on politicians to come up with affordable housing policies and zoning reforms. And higher commodity prices could lead to political pressure to de-escalate the emerging tariff wars.

This might mean letting inflation run somewhat hot for several years, but ultimately the narrow price increases might be what we need to address these supply bottlenecks. That – unlike chasing an arbitrary target without regard to collateral damage – is a real solution to a real problem.

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