The FT recently ran an article by Philipp Hildebrand entitled, “The old inflation playbook no longer applies”, which warned against the Fed adopting an excessively hawkish policy:

The Covid-19 shock and subsequent economic restart brought on supply constraints of a magnitude greater than for decades. Inflation has risen to levels not seen since 1982. Yet, far from running hot overall, the economy has not even reached its estimated potential level of output and employment.

We therefore find ourselves in a fundamentally different situation from the one Paul Volcker faced when he became chair of the US Federal Reserve in 1979. Then, the economy was running hot and the aim was to drive inflation that had become embedded out of the system.

I still have vivid memories of the 1970s.  At the time, we were told that the problem was “supply shocks”.  We were told that the economy was running below potential and hence the problem could not be excess demand. (It clearly was excess demand.) Economists aren’t very good at estimating the economy’s potential, and it is a big mistake to have the Fed target real variables such as an output gap.

Contrary to Hildebrand’s claim, the economy is probably now operating above potential, given the drop in potential caused by Covid.  Many economists miss this fact because they rely on the assumption that potential should rise by a couple percentage points each year.  By that criterion, we are slightly below potential.  But Covid has clearly reduced potential output.  If Covid goes away or even becomes a minor issue, then potential might quickly rise back up to the trend line.  Or it might not. 

In fact, the old inflation playbook still does apply.  Here’s my playbook:

1. If inflation rises sharply at a time of modest NGDP growth (as in 2008), then a more hawkish policy is not needed.

2. If inflation rises sharply at a time when NGDP growth is excessive (as in 2022), then a more hawkish policy is needed.

Some people were hawkish in the 2010s and are hawkish in 2022.  Some people were dovish in the 2010s and are dovish today.  Wise owls were dovish in the 2010s and are hawkish today. 

Don’t be a permahawk or a permadove.

Note that there is also much I agree with in Hildebrand’s article:

Needless to say, central banks should take their foot off the gas this year by removing the extremely accommodating stance of monetary policy and return rates to a more neutral setting. The resumption of activity — unlike a normal recovery — doesn’t require stimulus to be maintained. But what they should not do at this juncture is slam on the policy brakes, deliberately to destroy activity.

So I differ not so much with his policy conclusions than how he gets there.  I’d like to see 3% to 4% NGDP growth over the next few years to restore Fed credibility.  I fear that nominal growth will be considerably higher.  Still, there are much worse problems, and we had them in the 2010s, in the 1970s, in the 1930s, and in the 1890s.  Be thankful for that.

HT:  Julius Probst