Overheating the Economy Now Could Mean Trouble Later

It’s official: President Biden will seek to keep Jerome Powell at the helm of the Federal Reserve for another four-year term. Mr. Powell has his work cut out for him. With inflation rising to alarming levels, the Fed should be making moves to cool the economy. But under its dual mandate the agency is also obligated to ensure maximum sustainable employment.

At present, the Fed is erring too much on the side of maximum employment. Instead, Mr. Powell must tip the scales back in favor of price stability. If he doesn’t, he risks inviting a sluggish economy — or even a recession — in the coming years.

The Fed’s loose monetary policy — keeping the key interest rate it controls close to zero and purchasing large quantities of government bonds and mortgage-backed securities — provides juice to the economy and increases employers’ need for workers. It has contributed to troubling price increases that show signs of accelerating. On net, over half of small businesses, the highest on record, plan to increase their prices in the next three months, according to a National Federation of Independent Business survey. Investors in the bond market expect inflation to average around 3 percent over the next five years — nearly double their expectation from one year ago.

By running the economy so hot, Mr. Powell may think he is giving idle workers their best shot at re-entering employment. At present, there are six million fewer jobs than there would have been without the pandemic. Among workers ages 25 to 54, work force participation is down 1.4 percent from the start of the pandemic in February 2020. The rate for younger workers is 2.1 percent lower, and workers over the age of 54 have a nearly 5 percent reduction in participation.

As he enters his second term, Mr. Powell must confront the fact that many of those missing workers aren’t coming back. A large share of them have taken early retirement or are otherwise reluctant to return to their prepandemic lives. Inflationary monetary policy and a hot economy won’t change most of their minds.

Many others might come back under the right circumstances. They are temporarily on the sidelines because of Covid fears, child care problems, swollen bank balances and excessively generous government programs.

But by the time they are ready to return to the work force next year, the economy could be slowing under the weight of inflation. And as concerns about inflation become more ingrained in the psychology of consumers and businesses, the threat of fast price growth might leave the Fed with no choice but to rapidly increase interest rates, communicating to investors and businesses that it is worried about the economy.

This would slow business and consumer spending, possibly shutting even more workers out of jobs. So what seems like the pro-labor move — taking less aggressive action to fight inflation — is actually the riskier option for workers.

Mr. Powell has indicated that the Fed will wind down its purchases of Treasury and mortgage-backed securities over the first half of next year. After that, it will probably begin increasing interest rates in the summer.

Instead, Mr. Powell should immediately take tougher action to fight inflation. Rather than slowly reducing its purchases of mortgage-backed securities, given the white-hot housing market, the Fed should immediately stop buying them. It should aim to eliminate all additional asset purchases by the time Fed officials hold their March meeting, not June.

In addition, the Fed should signal that it expects to begin raising interest rates early in 2022, and that it is willing to increase rates several times next year. It should also more clearly acknowledge the threat inflation poses to household finances, business psychology and to the economy as a whole.

If this works, the Consumer Price Index may still be growing at an uncomfortable clip in the third quarter of 2022, but at a much slower pace than it is today and otherwise would be. This would accommodate a gradual and steady labor-market recovery while avoiding the risk of the Fed abruptly throwing the economy into reverse.

But it’s not just unwise Fed policy that could damage the economy. President Biden’s Build Back Better agenda would make our already troubling inflation problem worse. According to the nonpartisan Congressional Budget Office, this ambitious agenda would increase the deficit by around $300 billion over 2022 and 2023. The bill would also increase household income through more generous tax credits and deductions, encouraging consumer demand and putting upward pressure on inflation. Moreover, the one-year expansion of the child credit in the current bill could be extended. If so, Build Back Better would increase the deficit by around $400 billion over the next two years.

The White House argues that Build Back Better will reduce inflation over the next decade, and a few components of it might do that. For example, if its child-care provisions make it easier for parents to work, that would put downward pressure on wages and prices.

But even if they eventually materialize, any disinflationary forces won’t have kicked in next year. It will take time for the bill’s new programs to come online, and for people to rearrange their lives to take advantage of them. On the other hand, the extra demand for goods and services generated by the bill’s boost to household income would happen next year, as soon as government checks are deposited in people’s bank accounts. For purposes of taming inflation, what matters most is the effect the bill will have over the next year or two.

Some may think the bill is worth the cost of higher inflation, or even a recession. But this is a false choice: Mr. Biden will still be president in 2022. He should wait to see how the economy evolves before deciding if building back better will make things worse.

Of course, concerns over inflation and the recovery of the work force may well turn out to be overwrought. But Mr. Powell faces a very different economy now than he did when he assumed leadership of the Fed in 2018. Today, the balance of risks favors more aggressive tightening — immediately.

Michael R. Strain (@MichaelRStrain) is a senior fellow and the director of economic policy studies at the American Enterprise Institute.

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