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Inflation Dos and Don’ts

Today’s inflation is driven largely by supply-side constraints, which call for supply-side solutions. Such measures would do as much to tame higher prices as limited increases in interest rates would, and they would not come at the expense of American workers and the broader economy.

NEW YORK – In the decades since the 1970s oil-price shocks sent inflation soaring and shackled economic growth, price stability was maintained even when growth was robust. Many policymakers and economists took a bow, proudly claiming that they had found the magic formula. Underpinning the so-called Great Moderation were independent central banks that could anchor inflationary expectations by credibly committing to raise interest rates whenever inflation reared its ugly head – or even act preemptively when necessary. Independence meant that central banks need not – and typically did not – worry about balancing the costs (generally lost output and jobs) against any putative benefits.

But this conventional wisdom has always been challenged. Because interest-rate hikes achieve their intended outcome by curtailing demand, they don’t “solve” inflation arising from supply shocks – such as sharply rising oil prices (as in the 1970s and again today) or the kinds of supply-chain blockages seen during the COVID-19 pandemic and in the wake of Russia’s war in Ukraine. Higher interest rates will not lead to more cars, more oil, more grain, more fertilizer, or more baby formula. On the contrary, by making investment more expensive, they may even impede an effective response to supply-side problems.

The 1970s experience offers some important lessons for the current moment. One is that large increases in interest rates can be very disruptive. Consider the Latin American debt crisis in the 1980s, which had lingering effects lasting almost two decades. Another lesson is that “soft landings” piloted by central banks are especially difficult to orchestrate.

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