Sadomonetarism is having a moment. And one of the biggest risks the US economy now faces is that it will have too much influence on politics.
By the way, this term was introduced William Keegan describe the economic policies of Margaret Thatcher. But sadomonetarist has come to mean a man who always seems to demand higher interest rates and fiscal austerity, regardless of the state of the economy.
And these people have just had a good year: the inflation they always warned about has finally materialized. In 2021, American politicians, like many economists, including myself, have grossly underestimated the risks of inflation – as they themselves admit. This frankness, by the way, is refreshing and welcoming in itself. Back in the 2010s very little of those who erroneously predicted runaway inflation ever admitted they were wrong.
More importantly, politicians are trying to correct their mistakes. The budget deficit is shrinking. The Federal Reserve has begun raising interest rates, which it controls, and long-term rates that matter to the real economy, especially mortgage rates and the cost of corporate loans – took off. This policy largely provides for a slowdown in the US economy, which may be sharp enough to be considered a mild recession.
But there is a loud chorus of voices insisting that the Fed should tighten even more—moreover, that it should crash the US economy. long period of high unemployment something like the big recession in the early 1980s. And there is a real danger that the Fed could be forced into an overreaction.
So let’s talk about why the Fed’s demands for even more aggressive action are misguided.
First, how did inflation get so high? Much of the story is about upheavals such as rising oil and food prices, disruption of supply chains, etc., that are out of the control of politicians, that is, politicians other than Vladimir Putin, whose invasion of Ukraine caused serious damage to the global economy. These non-political upheavals explain why inflation has risen sharply almost everywhere – for example, inflation in the UK just hit 9.1 percent.
Unfortunately, this is not the whole story. At least in the United States, inflation is not limited to a few troubled sectors; even measures that avoid sudden price changes show inflation well above the Fed’s 2 percent target, albeit well below the numbers you might see in the headlines. And the swing of inflation suggests that a combination of big federal spending last year and easy money caused the economy to overheat—that we’re suffering from a classic case of too much money chasing too few goods.
However, as I said, politicians have already taken decisive steps to cool the economy again. So why isn’t it enough?
The answer I hear all the time is that in order to restore authenticity. And frankly, there is good reason to believe that trust is an important factor in curbing inflation. What we don’t have are good reasons to believe that this trust has been lost.
Economists have long accepted the idea that persistent inflation can be self-reproducing. By 1980, for example, almost everyone expected high inflation to continue indefinitely, and these expectations were reflected, among other things, in large wage deals that gave inflation a lot of momentum. So Paul Volcker, the Fed chairman at the time, had to impose a severe, prolonged recession to break the inflationary cycle.
But apart from the Sadomonetarists themselves, who currently expects inflation to remain consistently high (as opposed to remaining high, say, next year)?
Not financial markets. Wednesday Five Years break even inflation rate — an indicator derived from the spread between U.S. government bonds protected and unprotected against inflation — was only 2.74 percent. And in part this reflects expectations of short-term price increases, which investors do not expect to continue; markets expect inflation to subside.
And what about the general public? Last month, economists at the Federal Reserve Bank of New York, which conducts regular surveys of consumer expectations, noted that consumers apparently expected inflation to “decelerate over the next few years” and that five-year expectations were “surprisingly stable”.
A few weeks ago, another study by the University of Michigan showed hit in long-term inflation expectations, which were previously stable. But New York Fed numbers didn’t show the same punch. And, as anyone who works with economic data will tell you, you shouldn’t put too much weight on one month’s data, especially if the other numbers don’t tell the same story.
To be clear, I am not claiming that any of these predictions are necessarily true. Instead, they tell us that expectations of constant inflation have not taken hold in the way they did in 1980. So it doesn’t look like we need a Volcker-style hardliner that punishes the economy until morale improves.
Inflation is a real problem and the Fed needs to tighten it up. But it will be tragic if the Fed listens to people who, in fact, are demanding a much deeper recession than the economy seems to need.