The person who finally ended this wage-price spiral was Paul Volcker, who became the Fed chair in 1979. Volcker made clear that fighting inflation was his top priority and that he would push short-term interest rates as high as necessary to get inflation under control. But the post-Covid inflation is not similar to the Great Inflation of the 1970s and 1980s.
Nevertheless, the belief that unanchored expectations were to blame for the pain of the 1970s is shared by many in conventional macroeconomic circles and, most importantly, within the Fed. In a speech earlier this month, New York Fed president John Williams argued: “Anchoring of longer-term expectations is critical to keeping high inflation from becoming embedded in the psychology of consumers and businesses, which we know from the past is costly to undo.”
But a review of the relevant theoretical and empirical literature, in 2021, by Fed economist Jeremy Rudd, suggests that this belief rests on extremely shaky foundations.
In July and September, Fed staff announced that they were no longer forecasting a recession in 2024, marking a sharp departure from earlier projections. Unfortunately, the Fed may have to experience a sharp recession to realise that focusing too much on inflation expectations can be dangerous.
Tighter credit conditions, higher interest rates and company bankruptcies are already weighing on many sectors, but the plain effect on the whole economy is coming in a few months or quarters.
Interest on federal debt will become the second-largest category of government spending over the next year.
Christophe Boucher is chief investment officer of investment solutions at ABN Amro and a professor of economic and finance at University of Paris Nanterre
