Fretting About Inflation May Be Just the Cure We Need

To stave off runaway price hikes, the country needs to be reassured that the Federal Reserve still has its hand on the leash.

Inflation is low. So are interest rates. More than $3 trillion of Covid-19 relief spending in 2020 apparently had no negative macroeconomic consequences. So why are a few top economists suddenly worried about the size of the federal budget deficit? Perhaps because they fear a policy regime change.

When most people hear the phrase “regime change,” they think of war. But in macroeconomics, a regime change means that there’s been a shift in the rules by which policymakers make policy. If the Federal Reserve decides that it’s going to cut interest rates because the economy is bad, that’s just business as usual; It’s following the typical rule. But if it decides that the costs of low rates are lower than it thought, and therefore that interest rates should be maintained at a lower level in general, that’s a regime change.

The kind of regime shift that macroeconomists typically worry about the most is if the government becomes more tolerant toward inflation. In a famous 1982 paper, the Nobel-winning economist Thomas Sargent hypothesized that ruinously high inflation is kickstarted when the government decides to run much bigger deficits in perpetuity and the central bank decides to fund these deficits by creating money.  Hence, inflation accelerates because there is no longer the expectation that it will ever be controlled.

Conversely, economists Jonathon Hazell, Juan Herreño, Emi Nakamura and Jón Steinsson, looking at the U.S. experience of the 1970s and early 80s, suggested last year that then-chairman Paul Volcker’s interest rate hikes were able to tame inflation precisely because they strongly signaled that the Fed had become permanently less tolerant of rising prices. They write:

“Beliefs about inflation in the long run are governed by beliefs about the long-run behavior of the monetary authority and ultimately the political process that shapes the long-run behavior of the monetary authority.”

If that’s true, it means that inflation will only strike the U.S. if and when people believe that the government is willing to tolerate it — in econ jargon, if inflation expectations become unanchored from the Fed’s official 2% inflation target.