Daniel K. Tarullo, who served on the Federal Reserve Board and the Federal Open Market Committee from 2009 to 2017, says the Federal Reserve and its chair, Jerome Powell, are between a proverbial rock and a hard place as they struggle to curb inflation while supporting economic recovery after two pandemic years. In advance of the Fed’s next meeting on Jan. 25, Harvard Law Today asked Tarullo, the Nomura Professor of International Financial Regulatory Practice, to weigh in on the causes of, and prospects for taming inflation.

Harvard Law Today: Should the Federal Reserve Bank already have started raising rates? Are we behind the curve in terms of curbing inflationary expectations?

Daniel Tarullo: There is a widespread, though not quite unanimous, view among people familiar with monetary policy that the Fed has, indeed, fallen behind the curve. That’s the case even though many of those same people hold different views as to the causes of the sustained inflation of 5-7% over the last year. Implicitly, at least, the leadership of the Fed has acknowledged as much, as evidenced by the emphasis on containing inflation that we heard from both Chair Powell and Governor [Lael] Brainard at their confirmation hearings earlier this month. I should add that there’s considerably less agreement as to how exactly how far behind the curve the Fed has fallen.

HLT: What has happened in the past six months to have caused the Fed to change its view?

Tarullo: The simplest answer is just the continuation of inflation numbers coming in so much above the Fed’s inflation target of 2%. For most of last year a majority of the Federal Open Market Committee [the group of officials that sets monetary policy] explained the high inflation numbers as the result of supply shocks associated with the COVID pandemic, which they expected to diminish over time. Last summer and fall, Fed officials would point to a couple of big price increases on products and give a plausible story of why that was a one-off phenomenon. But as prices rose on more and more products, the repeated characterization of the higher inflation rate as due to “transitory” factors became harder to sustain. There’s little doubt that supply chain problems and labor shortages associated with the pandemic have contributed, but it’s clear that the effect was not “transitory” in the sense that the Fed could wait for them to pass.

In truth, the dynamic that has played out is very close to that anticipated by those who in the first half of last year warned of sustained high inflation — significant constraints on supply because of COVID with a series of fiscal stimulus measures that, in the aggregate, more than compensated for income reductions from the pre-COVID period. In other words, aggregate supply has been reduced and aggregate demand has been somewhere between steady and increasing. The result, fairly predictably, has been higher prices.

HLT: Are the Biden Administration’s moves to curb inflation — releasing oil from the strategic petroleum reserve, keeping West Coast ports open longer hours, and scrutinizing industries in which prices have risen most quickly — likely to be effective?

Tarullo: The distressing fact for the administration is that it doesn’t really have good policy instruments for bringing inflation significantly down in the next couple of years — and certainly not before the mid-term elections this fall. Because of factors like rising rents and wages, there’s almost surely enough inflation momentum already baked into the economy that we’re likely to see inflation continue substantially above 2% this year. At the margin, action to relieve supply bottlenecks more quickly can be helpful. A revitalization of antitrust policy, which in my judgment is long overdue, may have some impact on inflation, but almost surely not in the next couple of years. In that time frame, it’s mostly up to monetary policy to make a difference.

The administration doesn’t really have good policy instruments for bringing inflation significantly down in the next couple of years.

HLT: Some progressives have blamed corporate price-gouging for rising prices and say more regulation and investigation of big business is needed. Is that a valid complaint?

Tarullo: I’m sure that there have been instances of businesses raising prices in circumstances that some would regard as gouging. But it’s hard to see the basic factors of reduced supply and increased demand as not more central to inflation right now.

HLT: On the other side, some conservatives have said that government spending — President Biden’s COVID-19 relief and infrastructure bills included — have fueled rising inflation and have cited that as a reason for blocking his ‘Build Back Better’ legislation. Is that a valid concern?

Tarullo: As I’ve already noted, there’s a pretty good argument for the proposition that the cumulative effect of the stimulus measures during the late Trump and early Biden administrations has been a significant contributor to inflation, especially because they were enacted alongside extremely accommodative monetary policy. But it’s very unlikely that the infrastructure legislation will have much effect. The spending will be spread out over many years and will hopefully increase the productive potential of the American economy — a disinflationary effect. It now seems improbable that Build Back Better in its original form will be passed. In any case, the merits of the various components of that proposal are not solely, or even primarily, a matter of fiscal stimulus. In the first instance, the debate should be about the relative urgency of the social needs (like childcare and energy transition) that are being addressed. The eventual fiscal impact will depend on lots of factors, including the period over which the contemplated spending would take place, the degree to which that spending will be offset by revenue increases, and overall economic conditions in the coming years.

HLT: Is inflation the inevitable price of achieving higher wages for some lower paid workers?

Tarullo: It’s important to differentiate between one-time effects, such as when the minimum wage is increased, and a cycle in which rising prices lead to higher wages, which are then eaten up by higher prices. There’s no guarantee that wages for lower-income workers will keep ahead of prices. And since lower-income workers have little, if any, discretionary spending, they have less of a buffer within which they can adjust as the prices of food, housing, and other necessities rise. Redressing income and wealth inequality is going to require profound shifts in labor markets, government programs, and redistributive policies.

HLT: In light of all this, what should the Fed be doing?

Tarullo: First of all, to get back to your first question, the Fed needs to play some catch-up. That means ending new purchases of government securities — as it has signaled it will soon do — and raising interest rates. At least several rate increases will probably be needed this year. Just how many depends on how the economy is progressing. The Fed is in a very delicate position — almost a Scylla and Charybdis type situation [trapped, according to Homer’s Odyssey, between two sea monsters]. On the one hand, it needs to be prepared to do what it takes to stop inflationary forces from becoming embedded in the economy, which would necessitate more dramatic tightening later on in order to wring high inflation out of the economy. On the other hand, the Fed doesn’t — and shouldn’t — want to unnecessarily endanger the progress that’s been made on employment by slamming on the brakes through a more or less mechanically executed set of rate increases. It’s going to be very hard to engineer the proverbial soft landing, in which inflation moderates without some impact on growth.

It’s going to be very hard for the Fed to engineer the proverbial soft landing, in which inflation moderates without some impact on growth.

HLT: The Fed is meeting this week. What are you expecting to come out of this meeting?

Tarullo: I don’t think anyone is expecting anything dramatic. The Fed has already announced an end to its purchases of government securities, and it would be very unlike Chair Powell and the current FOMC to increase interest rates at this meeting, since they’ve given no indication in recent weeks of an intention to do so. Most people are looking to the March meeting for the first rate increase.

But we should learn something from the tone of the FOMC statement and from Chair Powell’s press conference. The Fed has clearly discarded the “transitory” story, but — so far as we know — hasn’t really articulated an alternative view beyond looking at actual inflation numbers. Because monetary policy works with a lag and thus has to be forward looking, policymakers need at least a working view as to what will be happening in the coming quarters. It’s not as though there’s an obvious answer to that question. But the Fed needs some view in order to make decisions from meeting to meeting. So, I’ll be looking to see if the FOMC gives us a better idea as to what, in legal terms, we might call their theory of the case.

Many Fed watchers think a majority of the FOMC still believes that inflation will fall considerably as the supply shocks ease this year. But they haven’t stated a hypothesis that they — and the rest of us — can test as data comes in. Just to take one example: They might believe that the current low levels of labor force participation will increase because prime-age workers will be lured back into the labor market as the pandemic recedes and wages rise, with a consequent easing of the current very tight labor market. If a critical mass of the FOMC members subscribe to this view, then they can see if incoming data supports it and, if their expectation isn’t being borne out, adjust policy accordingly.