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This paper is part of an initiative from the Peterson Foundation to help illuminate and understand key fiscal and economic questions facing America. See more papers in the Expert Views: Inflation, Interest, and the National Debt series.
The pandemic, the war in Ukraine, and China’s zero COVID policies were extraordinary events. Each one acted like a meteor, striking the global economy and knocking it off its axis. The blows suspended the rules of gravity; the risk of inflation surged along with the risk of recession. The Great Moderation in inflation that defined much of the last four decades came to a halt — inflation returned with a vengeance.
The term “stagflation” was resurrected from the rubble of the 1970s, as people tried to make sense of the economic malaise we were facing. Some countries are already there, with inflation picking up even as their economies stall.
Central banks, including the Federal Reserve, rushed to play catch-up and cool demand to meet a chronically undersupplied world. They can’t grow food or pump oil, but they can reduce demand to derail the upward pressure that shortages are imposing on prices on a global scale.
Will the Fed succeed? And if it does, is the post-pandemic world likely to return to the low-inflation, ultra-low rate world we left? Or, have we gone through a wormhole into a more inflation-prone, higher interest rate, post-pandemic world?
The aging of the baby boom into retirement and the need to fund social security and health care for an aging population will only add to our debt loads. The trajectory of inflation and, by extension, interest rates will play a key role in determining our ability to service the debt associated with those obligations, let alone any other priorities that arise. Russia’s invasion of Ukraine and China’s escalating tensions with the U.S. over Taiwan have upped our focus on defense spending.
I am more confident than many of my peers when it comes to the first question. This is Chairman Jay Powell’s Paul Volcker moment. The former Fed Chair was known for breaking the back of inflation by triggering two deep recessions in the early 1980s.
The Fed is haunted by the stop-and-go policies that fueled the stagflation of the 1970s. It would rather we endure a recession than allow such a vicious cycle of eroding living standards, falling profit margins and elevated layoffs to take root today.
Financial markets have yet to fully grasp the Fed’s resolve on that front. They are expecting the Fed to rapidly cut rates, like it did in the past. The problem with that logic is that the Fed was trying to counter a drop in employment that could trigger a bout of deflation. Today, the opposite is occurring. A surge in employment is fueling a more prolonged bout of inflation; a rise in unemployment is necessary to stop that from happening.
Powell and his colleagues have admitted as much. They believe that the noninflationary rate of unemployment has risen to between 4 percent and 5 percent. That is well above the current low of 3.5 percent that the unemployment rate hit in July. A rise in unemployment of that magnitude would be consistent with the very definition of a recession. A larger increase is most likely necessary to cool, not just stabilize, inflation.
The answer to the second question is that we can’t return to the low-inflation, low-interest rate world; we can only go forward through the wormhole the pandemic opened:
Add an acceleration in extreme weather events triggered by climate change, and the world post-pandemic is likely to be more inflation-prone than the one we left. Floods, fires and record heat are damaging property, disrupting supply chains and stressing the entire energy grid. It is hard to produce during rolling blackouts and when you can’t get fuel to traverse a bone-dry Rhine River at any price.
Fiscal policy aimed at upgrading our dilapidated infrastructure and easing the transition to renewables could boost productivity growth and limit the rise in extreme weather events. But they alone can’t cure what ails us. Private sector investment remains tepid. Productivity growth fell at a record pace in the first half of 2022. Efforts to stem climate change can’t reverse the rise in extreme weather events; that goal is still a pipe dream.
The U.S. dollar and its role as a safe haven for investors is valuing the rise in Treasury bond yields, but at a price. A strong dollar intensifies import competition, increases the costs of bringing profits home from abroad and destabilizes developing economies. The Fed is the de facto central bank for the world. When it raises rates, many developing economies must match those hikes to defend their currencies. That stresses their ability to service their debt and ups the risk of a crisis.
Sri Lanka’s debt default was an extreme example but can’t be dismissed as a one-off event. Pakistan borrowed from China to avert a default in April, and has since turned for help to the International Monetary Fund.
Why do we care? Because what happens abroad does not stay abroad. We don’t know how a crisis elsewhere might wash up on our shores. Anything that stops the Fed from easing before inflation has been tamed risks a more prolonged bout of inflation and higher rates down the road.
The Fed will do its part to cool inflation. That may not be enough to keep inflation in check longer term. The post-pandemic economy is likely to be more inflation prone and subject to higher rates than the world we left behind.
Those shifts will increase the pressure on members of Congress to embrace fiscal policies that more closely align government revenues with spending. Either they do so voluntarily, or financial markets will make the decision for them. The latter is more earth-shattering in its own right than what we have seen from investors in recent years. Brace yourself. This time is truly different.
Diane Swonk's knowledge of economics is particularly broad with respect to the Federal Reserve and monetary policy as well as the labor markets. Started her career with money-center bank First Chicago and has won many awards in her career for her excellence in her profession and leadership in the broader business community. She climbed from entry-level to Director of Research and Chief Economist at Bank One, the merged bank. Before joining KPMG, Diane had her own economic consulting firm and worked at Grant Thornton. She spent the prior 10+ years as Senior Managing Director and Chief Economist at the financial services firm, Mesirow Financial. She served as an advisor to the Congressional Budget Office (CBO) and the National Economic Council (NEC) on a nonpartisan basis. She regularly briefs the regional Federal Reserve banks and the Board of Governors in Washington, DC. She has provided Congressional testimony on income inequality and how to preserve and bolster the quality of government statistics on the economy. She was honored by her peers as Fellow of the National Association for Business Economics (NABE) for her outstanding contributions to the field. She serves on the NABE statistics committee to advocate for better information on the economy. Diane serves on the board of the Posse Foundation in Chicago, an organization dedicated to increasing access to higher education. She is active in supporting scholarships and programs to diversity the ranks of economists with more women and underrepresented minorities with her alumni groups and work on the NABE Foundation. She is a member of many business groups, including the Economic Advisory Board of the US Chamber of Commerce, and the Council on Foreign Relations. Diane recently took over the growing economics team at KPMG to serve partners and clients, and to engage with the media to help showcase the firm’s many achievements. Diane was named one of the top 50 most influential economists during the pandemic. She has won numerous awards through the financial press and been recognized for her excellence in forecasting by the regional Federal Reserve banks.