Yesterday, I listened to some financial analysts discuss Fed policy on NPR. One remarked that there wasn’t much the Fed could do to bring inflation down this year, and that policymakers hoped for improvement in 2023.
I agree that Fed policy won’t have much impact on inflation this year. But that’s not because it cannot affect current inflation, rather because the Fed will likely choose not to do so. Thus far the Fed has not taken ANY significant steps to tighten monetary policy. They slightly raised their target interest rate, but with the equilibrium interest rate rising even faster, this effectively meant an easing of monetary policy. That’s why inflation expectations are rising, not falling.
If the Fed actually were to adopt a tight monetary policy, inflation would fall almost immediately. The misconception about long and variable lags is due to two factors:
1. The assumption that many prices are sticky.
2. The assumption that the Fed cannot affect the relative price of commodities.
The first assumption is true but misleading, while the second is false. When the Fed adopts a dramatic change in monetary policy, the relative price of commodities responds immediately, and so does the overall price level. While it’s true that flexible prices respond more quickly than sticky prices, the former are an important enough part of the CPI to have an immediate impact on inflation.
When the Fed adopts a very tight monetary policy, as in late 1929, NGDP falls sharply. Both prices and output fall, with the fall in commodity prices being much more rapid than the fall in stickier goods prices. Thus the relative prices of commodities (which are unusually sensitive to the business cycle) tend to fall with tight money. This means the Fed can affect relative prices in the short run (but not the long run.)
In April 1933, the US adopted an extremely expansionary monetary policy that caused rapid growth in NGDP. Both prices and output immediately rose at a rapid pace. Again, commodity prices rose much faster than the prices of other goods.
Today, a dramatic move toward tighter money would cause relative commodity prices to decline almost immediately. Headline inflation would fall substantially, even in 2022, although the decline in core inflation would be more gradual.
[As an aside, actual inflation would fall faster than measured inflation, as there are problems with the way the Fed measures things like housing costs. But even measured inflation would decline.]
The fact that inflation is not slowing right now is not an indication that the Fed’s tight money hasn’t yet begun to work; it’s a sign that the Fed has not yet adopted a tighter monetary policy. Let’s hope they do so in the near future. I’d like to see them bring NGDP growth down to no higher than 4% in 2022.