Sado-monetarism is having a moment. And one of the biggest risks now facing the U.S. economy is that it will have too much influence over policy.
This term, by the way, was coined by William Keegan to describe Margaret Thatcher’s economic policies. But sado-monetarist has come to mean a person who always seems to demand higher interest rates and fiscal austerity, regardless of the state of the economy.
And such people have just had a good year: the inflation they’ve always warned about finally materialized. In 2021, U.S. policymakers, like many economists, myself included, badly underestimated inflation risks — as they themselves admit. This candor, incidentally, is itself refreshing and welcome. Back in the 2010s very few of those who wrongly predicted runaway inflation ever admitted having been wrong.
More important, policymakers are acting to undo their mistakes. Budget deficits are plunging. The Federal Reserve has begun raising the interest rates it controls, and the longer-term rates that matter for the real economy — especially mortgage rates and corporate borrowing costs — have soared. These policies pretty much ensure a slowdown in the U.S. economy, which might be sharp enough to be considered a mild recession.
But there’s a loud chorus of voices insisting that the Fed must tighten even more — indeed, that it must drive the U.S. economy into a sustained period of high unemployment something like the big slump of the early 1980s. And there’s a real danger that the Fed may be bullied into overreacting.
So let’s talk about why the demands for even more aggressive Fed action are misguided.
First, how did inflation get so high? A large part of the story involves shocks like rising oil and food prices, disrupted supply chains and so on that are outside the control of policymakers — that is, policymakers other than Vladimir Putin, whose invasion of Ukraine has seriously damaged the world economy. These nonpolicy shocks explain why inflation has soared almost everywhere — for example, British inflation just clocked in at 9.1 percent.
Unfortunately, that’s not the whole story. In the United States, at least, inflation isn’t confined to a few troubled sectors; even measures that exclude extreme price changes show inflation running well above the Fed’s 2 percent target, although well below the numbers you may see in headlines. And the breadth of inflation suggests that the combination of large federal spending last year and easy money has caused the economy to overheat — that we’ve been suffering from a classic case of too much money chasing too few goods.
As I said, however, policymakers have already taken strong steps to cool the economy back down. So why isn’t that enough?
The answer I keep hearing is that harsh policy is necessary to restore the Fed’s credibility. And to be fair, there are good reasons to believe that credibility is an important factor in keeping inflation under control. What we don’t have are good reasons to believe that this credibility has been lost.
Economists have long accepted the idea that persistent inflation can be self-perpetuating. By 1980, for example, almost everyone expected high inflation to continue indefinitely — and these expectations were reflected, among other things, in big wage deals that gave inflation a lot of inertia. So Paul Volcker, the Fed chairman at the time, had to impose a severe, extended slump to break the inflationary cycle.
But aside from the sado-monetarists themselves, who currently expects inflation to remain persistently high (as opposed to staying high for, say, the next year)?
Not the financial markets. On Wednesday, the five-year breakeven inflation rate — a measure derived from the spread between U.S. government bonds that are and that aren’t protected against inflation — was only 2.74 percent. And part of that reflects expectations of near-term price rises that investors don’t expect to continue; the markets expect inflation to fade.
What about the general public? Last month economists at the Federal Reserve Bank of New York, which carries out regular surveys of consumer expectations, noted that consumers apparently expected inflation to “fade over the next few years” and that five-year expectations had been “remarkably stable.”
A few weeks ago a different survey, from the University of Michigan, showed a bump in long-term inflation expectations, which had previously been stable. But the New York Fed numbers didn’t show the same bump. And as anyone who works with economic data can tell you, you shouldn’t make too much of one month’s number, especially if other numbers don’t tell the same story.
To be clear, I’m not saying that any of these predictions are necessarily right. What they tell us, instead, is that expectations of persistent inflation aren’t entrenched the way they were in 1980. So it doesn’t look as if we need harsh, Volcker-type policies that punish the economy until morale improves.
Inflation is a real problem, and tighten the Fed must. But it will be tragic if the Fed listens to people who are in effect demanding a much deeper slump than the economy seems to need.