'Hot' inflation and employment fears require a balanced Fed approach

Andrew Levin, former special advisor to the Fed Reserve Board and professor of economics at Dartmouth College, talks to Yahoo Finance's Adam Shapiro and Seana Smith about the Fed's next interest rate hike, inflation, employment, and President Biden signing the infrastructure deal into law.

Video Transcript

- Richmond Fed president, Tom Barkin, just telling "Yahoo Finance" a couple of things. One, he was weighing down on inflation. Two, he weighed in on the trillion dollar infrastructure deal that President Biden signed into law earlier this afternoon, earlier in the show, saying that he doesn't think it's going to stimulate the economy in the short-term. He also told us what he expects to see in terms of the supply chain crisis.

But we want to bring in Andrew Levin-- He's the former Fed board special advisor and also Professor of economics at Dartmouth. --with his reaction to what we just heard from president Barkin. And Andrew, it's good to see you. Thanks so much for jumping on here.

So President Barkin-- Let's start off, I guess, with this infrastructure comment, saying that the deal is not going to boost. He doesn't expect it to boost the economy in the short-term. He also expects to see some of these supply chain issues lasting into next year. What do you make of his comments?

ANDREW LEVIN: Well, I think the good news is the real economy is holding up well. We'll get a new retail sales report tomorrow. It's expected to be pretty strong. President Barkin referred to the fact that many American households were able to put aside a lot of savings during the worst part of the pandemic, and now they're drawing into that to some extent.

But I think what's really clear is that the Fed is going to have to recalibrate its policy strategy soon. It could be as early as next month at the December FOMC meeting or it could be at the end of January. But the markets now-- I just checked the CME Fed watch tool-- The markets are expecting three or four hikes next year. The Fed's, up until now, has said that they would not start raising interest rates until we've reached full employment.

I think it's very clear we're not going to be at full employment, certainly not on our broad-based inclusive basis. We're not going to be at full employment by the middle of next year. But because inflation's running hot, the Federal Reserve needs to respond. It has to take a balanced approach to maximum employment and price stability. And again, that's going to require a pretty substantial recalibration.

- And Andrew, didn't he allude to the difficult balancing act they're going to have when they try to do what you just talked about-- recalibrating-- because the stimulus bill or the infrastructure bill rather. He alluded to the fact, there's not enough people out there in the infrastructure trades to hire right now to do everything we want to do. So that's going to put pressure on wages as companies try to fulfill the spending that's coming that way. How do they reconcile all of that?

ANDREW LEVIN: Well, so some of these things are going to take place over months and quarters and years. We used to talk about shovel-ready projects. I think a lot of this is going to evolve over time. But what's clear-- and I just wanted to disagree strongly with something that several Federal Reserve officials have been saying lately-- the cost of living is rising at 5% or 6%.

It's very reasonable for workers to expect to get a cost of living increase of 4% or 5% or 6%. Some of them can't get it. The business they're working for can't afford to give them any cost of living increase. Many of those people are the ones who are quitting. The ones who are getting a raise of 6%, it's not that the workers are greedy. That's just keeping up with the cost of living.

And so I think what we're starting to see here is a dynamic where businesses that are able to give their workers a 6% cost of living increase then have to pass that through into prices. We used to call this a wage-price spiral. The word spiral is a little bit alarming. But I think what is certainly true here is that we have a dynamic now where wages are rising in line with the cost of living. Then that creates a persistence and the increases in the cost of living. And these are going to go on, not just for a few more months, but probably for several more years. So again, the Fed needs to recalibrate.

- Yeah, and as you're just going off of that, I guess, how would you characterize the strength of the consumer right now? Because we've seen the consumer be extremely resilient. We have been able to absorb some of those higher prices. But if some of these companies, like you're saying, don't come out and give those 5% to 6% raises, are we going to see a pullback or potentially a significant pullback in spending?

ANDREW LEVIN: Well, I think that, again, the retail sales will see tomorrow. But the expectation is it should be pretty strong. So fortunately, many consumers do have some savings. But a lot of consumers are worried. They're having to tighten their belts. Workers who haven't quit their jobs so far have only gotten about a 3% increase in their pay over the past year.

OK, they're not keeping up with the cost of living. You can understand why those people are not happy. So again, we're probably facing a world where inflation is going to be running well above the Fed's target over the next several years. That's what consumers are expecting now. They expect inflation to run in the neighborhood of 4%, 5%, 6% over the next several years. And I think those consumers are probably right. So that calls for the Fed to readjust its stance.

- Why are the inflation expectations perhaps more important and also more burdensome than the actual real data?

ANDREW LEVIN: Well, again, the real data is-- We had a CPI reading of 0.9% for a month. Now if you just multiply that by 12, you can see we're in double-digit territory for inflation. People have talked about, this is the first time we've seen some of those kinds of numbers in many decades. So it's no wonder that households are very concerned about how they're going to meet their budget, how they're going to make ends meet.

And those families are asking for pay increases from their business, which is reasonable for them to ask so that they can meet their budget. Then those businesses have to pass on those pay increases to their customers. And this is how we get a very persistent, elevated level of inflation. Again, it's going to call for the Federal Reserve to recalibrate its strategy.

- Andrew, just talking about what we heard from President Biden earlier today signing the $1.2 trillion infrastructure deal into law. There's some questions out there, whether or not more spending-- if it's going to make inflation worse. Do you see this package having a substantial impact on inflation?

ANDREW LEVIN: Well, as I understand it, the actual new spending in the package is not really $1.2 trillion. Some of that was already scheduled to take place. And so, when you take the actual amount of new spending, it might be half of that. Again, we can quibble about details here, but that spread out over a number of years.

The total size of the US economy now is more than $20 trillion. So we're talking about a pretty small sliver. Those infrastructure projects are important that's why it was a bipartisan agreement to adopt that legislation. But I think that the problems with inflation that we're facing are much more related to the pandemic and to the supply chain issues and to other factors that we hoped would be quickly unwound and they're not. And so the Federal Reserve needs to respond.

It needs to change its policy guidance, because up until now, the Federal Reserve has been repeating over and over again that it would hold off on starting to lift interest rates until we reach full employment. The Fed has to take a balanced approach in fostering both maximum employment and price stability.

- Andrew Levin, we have to leave it there. Thanks so much for jumping on with us. Former Fed board special advisor and Professor of economics at Dartmouth.