In the third part of our April 7, 2022 “The Future of Inflation” trilogy, “The Electronic Money Standard and the Possibility of a Zero Inflation Target,” Ruchir Agarwal and I write:

Despite the surge in inflation worldwide, central banks have been behind the curve in raising rates. One reason is the reliance on forward guidance instead of negative interest rate policy. At the onset of the COVID-19 crisis, most advanced country central banks lowered their rates to the effective lower bound (but not deeper into negative territory) and thus had to deploy ‘forward guidance’—by committing to maintain the near-zero rates until they were confident that the economy was on track to achieve employment targets. However, such forward guidance tied the hands of several central banks when faced with rising inflation—leading to a sluggish interest response to record-high inflation. Tying their hands with a forward guidance promise was especially unfortunate given the unprecedented nature of the shock.

And for Mitra Kalita’s August 9, 2022 newsletter post “We're Asking the Wrong Question About the Recession,” I crafted two unused quotes (quoting from my email to her):

• Because raising rates too late means it is typically necessary to engineer a recession to bring down inflation, the Fed, in effect, caused the coming recession by failing to take decisive action earlier. What might decisive action earlier have looked like? Instead of waiting to raise rates until April 2022 and starting slowly, the Fed should have raised rates by 3/4 of a percentage point in December 2021 and announced that it would keep raising rates by 3/4 of a percentage point at each meeting until it saw clear signs that inflation was headed back all the way to the 2 % target rate. The Fed had enough information by its December 14-15 meeting to make that call.

• Thinking falsely that it couldn't fall back on negative rates, the Fed was too slow and timid in raising rates for fear that it didn't have the firepower to quickly reverse a recession if it went too far in raising rates.

Now in his August 26, 2022 Wall Street Journal essay “Can Central Banks Maintain Their Autonomy?” I see that Nick Timiraos, the doyen of monetary policy journalists, takes a similar view of why the Fed and other central banks were behind the curve in raising rates. He writes:

Finally, the pandemic struck just as U.S. and European central bankers were concluding reviews of the policy frameworks they had used to address the problems bedeviling their economies since the 2008 crisis. They wanted to avoid a rut of slow growth and low inflation that would cripple their ability to stimulate the economy in a downturn. They had seen Japan struggle to escape that trap for most of the previous two decades, even after cutting interest rates to zero or below.

At Jackson Hole in 2020, Mr. Powell unveiled an overhauled policy framework. The Fed would aim to return inflation not just to its 2% target but rather to a level a bit above it, so inflation would average 2% over time. For the preceding decade, “We could not get inflation up to 2%,” said Fed governor Christopher Waller. “This sounds crazy. I used to always joke, ‘Go get the guys from Argentina. They know how to do it.’”

Part of the reason Fed officials waited too long to react to the recent surge in inflation is that “they wanted to be sure” that the problem of weak growth and inflation had been vanquished, said Mr. Rajan. “Imagine the hue and cry,” he added, “if they had raised rates immediately: ‘Why are you killing a sound economy?’”

This was in part, a matter of generals fighting the last war rather than the war they are in. But it was more than that. If you thought that fighting the war you are in would destroy all of your hardware for fighting a war like the last war, you could be clear about the war you were in and still hesitate to do what would otherwise be called for.

That is where having a full strength negative interest rate policy in reserve could help. If you know you can cut interest rates as much as necessary to quickly end any recession caused by inadequate aggregate demand, then you can raise rates with the confidence you can get back on track if you make a mistake and overdo it. If you are too afraid to overdo interest rate hikes, you are likely to underdo them. That is what happened.

The Fed has had the opposite problem in the past. In his August 25, 2012 Slate piece “We Need Inflation-Tolerance, Not Inflation,” Matt Yglesias writes:

Imagine you’re watching an Olympic-quality archer who’s having a very bad day. You notice that not only is his overall score much worse than he normally does, but all of his arrows are falling lower than the bullseye. You ask him about it and he tells you that his daughter’s been kidnapped, and the kidnapper says he’ll kill the girl if he shoots a single arrow above the bullseye. Now it all makes sense. The archer hasn’t lost his skill. He’s deliberately aiming too low because he has enormous aversion to shooting above the bullseye. If he lost that aversion, his score would improve.

The moral of the story isn’t that shooting too high is a good way to win an archery tournament. To win, you need to hit the bullseye—neither too high nor too low. But if you become strongly averse to shooting too high, that’s going to undermine your ability to hit the bullseye.

That’s the situation I think American monetary policy is in. It’s not that three or four percent inflation is such a wonderful goal. It’s that extreme aversion to three or four percent inflation is causing the Federal Reserve to persistently “shoot too low” in terms of aggregate demand. Ben Bernanke’s acting as if someone’s holding his daughter hostage. Specifically, the reigning dogma is that if inflation were to go from 2 percent to 3 or 4 percent that long-term expectations might become “unanchored” and drift higher and higher, undermining the “hard won gains” of the Volcker years. But there’s no empirical evidence that this is true, and no particularly strong theoretical reason to believe than the worst-case scenario if inflation tolerance goes wrong is worse that the current strategy of grinding the recession out by letting America’s long-term productive capacity collapse.

In the current context, it is easier to think about trying to hit the moving target of the “right” interest rate. But Matt Yglesias is correct that being too afraid of aiming high will make you aim too low. And being too afraid of aiming low will make you aim too high. The Fed and other central banks need to have tools they are confident can do the job in either direction. Then they can immediately take rates to the level that is their best guess of what is right for the battle they are in, knowing they can swiftly pivot if another threat emerges.

Coda: In the first part of our “The Future of Inflation” trilogy, “Will Inflation Remain High?” Ruchir and I write:

While advanced economy central banks may continue to dislike inflation, their current apparent plans—according to their current dot plots (or the equivalent)—may be behind the curve on what would be required to bring inflation back down. Standard Taylor Rule calculations suggest that it could easily take interest rates as high as 7 percent in several countries to bring inflation down.

This is above the level currently expected by markets. Matt Grossman’s August 26, 2022 news article “Bond Yields Inch Higher After Powell Says Fed Will Hold the Line on Inflation,” reports:

Earlier in the summer, market-based forecasts showed that many investors were second-guessing whether the Fed would wind up raising interest rates as much as central bankers have projected.

In late July, the pricing of derivatives called overnight index swaps estimated the Fed’s benchmark rate would peak at around 3.3% in early 2023 before moving lower again.

At the time, that was a much different outlook than the one espoused by Fed officials themselves, who have generally said they expect rates will have to hold steady or climb next year to corral inflation.

In recent sessions, traders’ forecasts have moved closer to the Fed’s. On Friday, derivatives traders were now projecting that rates will rise to nearly 3.8% by the end of the Fed’s May 2023 policy meeting.

3.8% is still a lot lower than the 7% or so I think will be necessary to bring inflation back to the 2% per year target. Since I believe the Fed is committed to getting inflation under control, I predict further market surprises as market participants and the Fed itself realize how high rates need to go.

See also:

• Ruchir Agarwal and Miles Kimball on Negative Interest Rates and Inflation—IMF Podcasts

• How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide