Beware the dangers of sado-monetarism

NEW YORK (NYTIMES) – Sado-monetarism is having a moment. And one of the biggest risks now facing the US 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, US policymakers, like many economists, myself included, badly underestimated inflation risks – as they themselves admit..

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 US 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 US 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 per cent.

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 per cent 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)?