Consumers' reliance on the Fed could be problematic: Economist

Inflation is not a new phenomenon for the U.S. economy. Although the Federal Reserve has sustained a higher-for-longer inflation environment, historical outcomes provide valuable insights. Brookings Institution Director of Economic Studies Ben Harris joins Wealth! to talk economic history.

Harris draws parallels to the 1970s and early 1980s, when "inflation lasted for roughly a decade." During that time, inflation reached a staggering 14%, he says, whereas inflation peaked at 9% most recently. While Harris acknowledges that though the current experience "wasn't as severe, some of the lessons were the same."

Harris emphasizes that monetary policy is the primary tool for combating inflation, stating that the Fed will "keep interest rates at what it deems to be an appropriate level until it has brought inflation down to around 2%." However, he notes a crucial difference: consumers today "believe in the Fed's credibility," which can influence behavior "in problematic ways."

As far as inflationary efforts go, Harris states, "We're now in sort of the last mile." He suggests that the big question now is, "How many additional high rates do we have to go through in order to get inflation down to 2%?"

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This post was written by Angel Smith

Video transcript

Now, for all the justifiable fears that Americans have about inflation.

It's not the first time the country's experienced rapid price increases, but it may be the first time in our lifetimes here.

But we've been here before and we were all ok.

So what can we learn from past inflationary periods to help us answer that?

We've got a fantastic guest.

He's the former Assistant Secretary of the Treasury Economic Policy.

He's also the current Brookings Institution, Vice President and Director of Economic Studies then Harris.

And thank you so much for being here.

We really appreciate it to understand this moment in time.

Help me out here, walk me through another moment in history where we could tame record breaking inflation and we did end up.

Ok. Yeah.

So we have had one other notable period of elevated inflationary country's history and that happened in the 19 seventies and early 19 eighties.

Now that inflationary period lasted for roughly a decade.

Uh This current inflationary period, we're only about 5% inflation for about 20 months versus 10 years.

Uh going back to the 19 seventies, early 19 eighties and inflation, the peak inflation in that, in that period was much higher.

It was around 14%.

So inflation only peaked at 9% this time, 14% before it was 10 years before.

It was only about two years for this time.

So it wasn't as severe.

Uh But some of the lessons were the same.

So what was the biggest headwind for inflation at that time?

What was an effective strategy for taming it?

And to what extent do you anticipate us being able to replicate that similar strategy?

Given that we're in a very unique time period here?

Well, you mentioned it earlier, we have one big tool for fighting inflation in general and that's monetary policy.

And so the Federal Reserve raises interest rates and will keep interest rates at what it deems to be an appropriate level until it has brought inflation down to around 2%.

1 of the really good news stories that come out of our recent inflationary episode has been that uh households and investors and people who participate in the economy believe in the fed's credit.

So if you ask households, do you think that inflation will stay around 2 to 3% over the next one year over the next three years?

People say yes, I mean, that's one of the one, no, the really troubling things with inflation is that if people start expecting prices to keep going up and up and up and over time, uh then they start changing their behavior in really problematic ways workers start saying, look, I wanted to account for uh this inflation in my next raise.

Uh companies when they're setting prices say, OK, we expect prices to go up over time.

Let's build in those price increases.

And then you get this problematic spiral over time that makes it much harder for the central bank to do its job.

Well, this is like my favorite debate ever.

Ben is whether or not the Federal Reserve has the amount of power that we think they do to tame inflation because they really got two levers monetary policy in terms of the interest rates and in terms of quantitative tightening and easing of the balance sheet.

At what point do we consider that we need some fiscal policy?

Some changes from the federal government to put a cap on inflation and prices going up at the company level.

Yes.

So fighting inflation is, is really a job of the Fed and the Fed has done has made a lot of progress so far.

So again, in, in uh the early part of the pandemic, we were at 9% inflation that was incredibly troubling.

And uh it was honestly scary, I think for a lot of households that's come down so far.

And so we're now at the sort of the last mile we're around 3.5% for the CP I uh a little bit lower for the P CE.

Uh but inflation is already down a lot in large part to the good work of the Fed.

So the big question now is how much additional uh higher rates do we have to go through in order to get inflation down to 2%?

Now, investors still expect 1 to 2 cuts over the course of 2024.

As your prior guest said that if we were speaking a few months ago, we might have expected 45 or even six cuts.

Uh So you hearing this term higher for longer, uh which is just the expectation the fed will have to keep rates elevated around the 5% range for a bit longer.

Um And you know, households will need to account for that when they're thinking through their budgets and they're thinking through their own personal forecasts.

But right now to get to your direct question, it does seem that the FED has made enormous amount of progress over the past couple of years and that we're pretty close to its goal.