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Inflation is raging and the Federal Reserve is raising interest rates. How will this resolve over the next few years? We foresee three possibilities.
The first is that supply shortages—which have been augmenting the inflation caused by easy money policy—dissipate. Perhaps by some miracle this, along with the Fed’s announcement of letting off the gas on money growth, slows inflation down. Under this scenario, the Fed achieves a soft landing: low and stable rates of both unemployment and inflation. This is what we and others call “the immaculate disinflation” scenario. It seems less likely every day. But it is a possibility we can hope emerges.
The second possibility is that the Fed does not do enough to slow inflation over the next year and inflation expectations rise. As of now the public expects about 3% inflation each year over the next five years. This is evidenced by the “Fed Spread” difference in the yield between inflation index and non-index government bonds. As of the time of this writing it is at 3.36%.
In our opinion, the only reason inflation expectations aren’t higher is that the Fed hasn’t lost all credibility in its commitment to lowering inflation. But if inflation remains elevated or rises over the next year, then the Fed will lose most of what’s left of its credibility. This would be awful because it would lock us into a high inflation equilibrium that will be disruptive but hard to exit.
In this scenario people come to expect higher money growth and higher inflation. Employees work this into pay negotiations with employers, borrowers work this into loan contracts with lenders, and vendors work this into supply contracts with customers. In such a wage-price-interest rate spiral, rising inflation becomes a self-fulfilling prophecy. And the public won’t like high and ever-rising inflation. But the only way out is to slam the brakes on the money supply and generate a depression-like hard crash.
The third scenario is that the Fed gets serious about combating inflation now. This brings down inflation but will likely cause a recession in the economy. This is what we have been warning about in these pages for a year now, and the likelihood rises by the day.
Personally, as Christians we have faith in the immaculate conception, even if it isn’t a scientific belief. But as economists we have little faith in immaculate disinflations. Put on your seat belts!•
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Bohanon and Curott are professors of economics at Ball State University. Send comments to ibjedit@ibj.com.
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