Ramesh Ponnuru: It’s not the Fed’s job to stop supply-side inflation

Vladimir Putin has made Jerome Powell’s hard job harder.

Even before the Russian president launched his invasion of Ukraine, the Federal Reserve chairman was under pressure to fight inflation without causing a recession – a high-wire act in which this week’s small interest rate increase was the latest move. The war is sharpening the dilemma, raising prices further while weakening the economy. The first effect tempts the Fed to move faster in hiking interest rates, the second to move slower.

Spoiler: This column is not going to try to resolve the dilemma of what the Fed should do. There is, however, a way to think about the trade-offs that may be helpful. It starts with discarding the idea that the Fed should be an inflation fighter at all.

Instead, think about two ways that inflation can rise. Sometimes it happens because of an acceleration in spending throughout an economy, and sometimes because of negative shocks to productivity.

In the first case, when increased inflation has a purely monetary cause – too much spending – the Fed should take responsibility for it. The Fed should see this kind of inflation, that is, as something it has done rather than something that has happened to it. Joshua Hendrickson, a professor of economics at the University of Mississippi, has explained that changing its viewpoint in just this way was key to getting inflation under control after the 1970s.

For much of the 1970s, the Fed had considered the real drivers of inflation to be such nonmonetary factors as the greed of oil-producing countries, big businesses and unions. That analysis cast central bankers as helpless to stabilize prices.

Inflation fell only when the Fed came to see the main issue as excess growth of the money supply, something it could control. But that meant understanding that the Fed was creating inflation rather than merely failing to stop it. As Hendrickson put it in an essay last month, the Fed excused itself as an ineffective firefighter when it was really an arsonist. It needed to quit pouring fuel.

In the second kind of inflation, the total amount of spending in the economy doesn’t spike. Instead, a negative supply shock means the same amount of spending buys fewer goods at higher prices. The Federal Reserve isn’t responsible for this kind of increase in prices and decrease in output. The question then becomes not whether the Fed can fight this inflation – it can – but whether it should.

Fixing supply chains is of course beyond any central bank’s power. What the Fed can do is reduce spending levels, which would in turn exert downward pressure on prices. But this would be a mistaken response to shortages. It would answer a scarcity of goods by bringing about a scarcity of money. The effect would be to compound the hit to living standards that supply shocks already caused.

One of the many sad deficiencies of the real world is that both of these types of inflation can occur at the same time. It happened in the 1970s, and it is happening today.

The conjunction opens the door to two mistakes. One is to attribute all of the inflation to supply shocks outside the Fed’s control, ignoring overspending, as the Fed did in the 1970s. The other mistake would be to treat the inflation as purely a matter of overspending, ignoring supply shocks. The Fed made something like this error in 2008: Fear of high gas prices led it to run an excessively tight policy that contributed to the Great Recession.

In theory, then, the right course for the Fed would be to set interest rates, and adjust its guidance about future interest rates, with a goal of stabilizing spending. At the moment, that means restraining its growth. It would accept only the portion of above-target inflation caused by supply shocks.

Easier said than accomplished, no doubt. But establishing that goal would help central bankers decide how much impact that Russia’s war – and, for that matter, China’s COVID-19 lockdowns – should have on monetary policy. There is a chance that world events will affect spending levels, say by making people nervous and leading them to cling to dollar balances rather than consuming and investing. But the more certain effect of turmoil abroad will be further disruption of supply chains.

And that shouldn’t sway the Fed. It needs to tighten money because it has let spending grow too fast. Its announcement this week that it is raising interest rates a quarter-point is a welcome, if probably inadequate, step in this direction.

But the Fed should not let supply-chain issues arising from Russia and China affect its judgment of how much and how fast it needs to tighten. It should not tighten further simply because these events are raising prices.

Nor should it tighten less simply because they are harming U.S. output. Putin has made the central bank’s picture muddier. But he hasn’t changed its mission.

Ramesh Ponnuru is a Bloomberg Opinion columnist. He is the editor of National Review, a contributor to CNN and a fellow at the American Enterprise Institute.