The COVID-19 inflation episode: Lessons from emerging markets


The COVID-19 inflation episode: Lessons from emerging markets



The Fed’s Easy Choices

Alice M. Rivlin
Alice Rivlin
Alice M. Rivlin Former Brookings Expert

May 15, 2000

With much fanfare, the press is building the suspense around tomorrow’s meeting of the Federal Reserve’s Open Market Committee. Will the Fed raise the short-term interest rate by a quarter point or will it—gasp!—go for a half? One might think the committee was facing a contentious decision whose resolution could affect the course of economic history.

Actually, conducting monetary policy right now is a no-brainer. The economy is growing too fast, and the Federal Reserve needs to keep raising the short-term rate—the only instrument it has—until growth slows to a more sustainable pace. Whether the committee raises the rate by a quarter-point tomorrow or a half or even more has little economic significance.

The choice is tactical: how best to send a message to businesses, investors and consumers to slow things down a bit so the economic engine can keep moving forward without overheating.

That much of the attention has been focused on the size of the rate increase highlights the fact that few disagree that tightening the economy is appropriate right now.

Some critics, especially in Europe, even believe the Fed has not moved aggressively enough to rein in what they regard as a fragile bubble economy, based more on equity speculation than solid growth.

But the remarkable productivity increases of the last three years are in fact solid. They are based on rapid technological change, and tight labor markets have clearly opened enormous opportunities to workers at all levels. If the Fed had raised rates sooner or faster, some benefits of the digital economy might have been delayed and many people would have been worse off.

Other critics regard all interest rate increases as pernicious and dismiss the risks to future expansion from incipient inflation, extreme worker scarcity and consumer spending out of paper wealth.

They argue that economists used to say that unemployment rates below 5 percent, or growth rates over 3 percent, would cause inflation, but those limits have been breached for some time without ill effect, so why not push unemployment down to 3 percent and growth up to 6?

These folks overlook that some of the special factors that have kept inflation low for the last several years are turning around.

Medical costs, after long quiescence, are climbing rapidly once more.

The weak foreign demand that held down the price of commodities and other products traded on world markets is reviving.

That the United States economy can, under favorable conditions, drive safely at high speeds, does not prove that it is safe at any speed, even when the road worsens.

Congress and the stock market have helped keep the economy in check. Congress, in not acting to reduce the mounting federal surplus by devoting the money to big tax cuts or major new spending programs, has helped slow the economy in the short run. And the recent drop in the stock market has also helped keep the economy from growing out of control. It seems that investors are remembering that earnings, or the firm prospect of earnings, ought to have some influence on stock values.

An additional market correction would help, but even if equity prices just wander sideways for a while, consumer spending is still likely to weaken and help ward off inflation.

So, stay in your seats. Tomorrow’s Fed decision won’t change the course of history. But with any luck it will help to keep the economy growing at a healthy and sustainable clip.