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America’s Wage-Price Persistence Must Be Stopped

The US Federal Reserve tried hope as a macroeconomic strategy last year and ended up contributing to today’s rapid inflation. Now that it has accepted the need for monetary-policy tightening, it must stay the course until inflation is no longer fueling wage growth and feeding back into further increases in the price level.

CAMBRIDGE – Recent price- and wage-growth data make it increasingly clear that the US economy’s underlying inflation rate is at least 4% and more likely to be rising than falling. Although the Federal Reserve has acted forcefully in recent months to contain inflation, unfortunately it will need to stick to its plan of rapid interest-rate hikes until there is clear evidence that underlying inflation is slowing dramatically. That is especially difficult when the economy is already slowing, but the alternative of deferring action while inflation becomes more entrenched would be much worse.

So far this year, the Personal Consumption Expenditures Price Index has risen at a 7.7% annual rate, well above the Fed’s 2% target. Some of that is fueled by external events, notably Russia’s invasion of Ukraine, which has driven up gasoline and food prices. And now that gasoline prices have begun to decline from their peak, headline inflation should fall sharply. Yet even if we exclude these volatile prices, “core inflation” is still running at an annualized rate of 4.8% and has been increasing recently. Moreover, other measures that strip out volatile components of the price index – such as trimmed-mean, median, services, and cyclically sensitive inflation – have all increased, and some by even more than core inflation has.

It is hard to make excuses for this inflation, let alone excuses that would justify the belief that it will go away on its own anytime soon. While Russia’s war on Ukraine raised the price of oil and food, these have only a small direct pass-through effect on core inflation, which itself is partly offset by behavioral changes as consumers cut back to account for higher gasoline and food costs. Moreover, COVID-19 is having a smaller effect on the economy than at any time since February 2020, and insofar as it was affecting inflation when it was rising, it was more likely lowering it than increasing it. Many commentators blamed supply-chain snarls for boosting goods-price inflation, but that measure has actually fallen and been replaced by a services inflation that is much more inertial. The weaning from pandemic-era fiscal-support policies was supposed to bring inflation down, but that process mostly ended more than a year ago.