A rising tide?

Harvard Law Professor and Federal Reserve Board veteran Daniel K. Tarullo discusses inflation and the United States’ economic recovery

As reports of rising prices for goods and services continue amid a surge in COVID-19 cases across the United States, Harvard Law Today reached out via email to Daniel K. Tarullo, Nomura Professor of International Financial Systems at Harvard Law School, for his perspective on whether inflation is here to stay, what tools the Federal Reserve Bank has to combat it, and the “delicate decisions” facing the central bank as it works to support the nation’s economic recovery. Tarullo, who served as a member of the Federal Reserve Board and the Federal Open Market Committee from 2009 to 2017, says persistently high inflation levels are hard to predict in advance. By the time the signs are clear, he says, it may be too late for the Federal Reserve to avoid taking actions that might lead to a recession, yet acting preemptively could unnecessarily choke off growth.


Harvard Law Today: Inflation is rising. Some experts seem to be extremely concerned, while others — including the Federal Reserve — believe it is transitory and largely due to a rebound from economic woes brought on by the pandemic. Why do the experts have such dramatically different views?

Daniel K. Tarullo: I should note first that inflation dynamics had not been especially well understood for a good while prior to COVID. The macroeconomic models used by central banks to project economic trends had not proven a good basis for predicting inflation rates, certainly not on the real-time basis necessary for central banks making monetary policy decisions.

Daniel Tarullo

Credit: Britt Leckman Daniel K. Tarullo is the Nomura Professor of International Financial Regulatory Practice at Harvard Law School.

The onset of COVID has further clouded the picture. There is no question that part of today’s headline inflation is due to so-called base effects — that is, the fact that the prices of many goods and services dropped during the height of the shutdowns means that as the economy normalizes those prices will rise more as they recoup the declines. So, on a 12-month rolling basis, inflation looks a good deal higher than if you look at the trend over the last two or three years. Additionally, the well-publicized shortages of important production inputs such as semiconductors have pushed up prices for motor vehicles, consumer electronics, and lots of other products.

The Fed, and many other observers, believe the waning impact of base effects and COVID-driven supply shortages will result in lower inflation rates in the next few quarters. The critics, on the other hand, believe that high fiscal deficits and continued accommodative monetary policy may fundamentally change the dynamics of the last couple of decades. To further complicate things, this disagreement is taking place against the backdrop of a debate over whether longer-term disinflationary trends are turning around as the populations of the United States and other countries age.

HLT: What, if anything, should the Federal Reserve do? Or Congress and the president? Is it a matter of waiting and seeing what happens, to some degree?

Tarullo: It’s important to understand that both the administration and the Federal Reserve are very consciously fueling — some of the critics would say overheating — the economy. The Fed has, rightly in my view, changed its understanding of the maximum employment that is possible without endangering price stability. And the administration aims to reverse the longer-term trends of wealth and income inequality, tepid productivity growth, and other chronic ills of the American economy. There are risks in pursuing these monetary and fiscal policies, but they are calculated risks. As evidenced in its July Monetary Policy Statement, the Fed is now talking about when to begin reducing monetary stimulus. How quickly they do so will depend both on the progress they see toward maximum employment and on whether there are stronger indications that inflation could continue higher above target for a longer period than makes the Fed comfortable.

HLT: If inflation continues to increase, does the Federal Reserve (or the federal government) have the tools necessary to tame it?

Tarullo: Yes, but the real question is what level of pain the Fed would have to inflict on the economy to do so. Because monetary policy acts with a lag, a central bank should ideally start tightening policy before higher than desirable inflation has begun to embed itself in the real economy. This allows for the economy to have a “soft landing,” during which it slows down gradually to a sustainable pace. But with inflation dynamics hard to understand, especially in these unprecedented conditions, there’s a risk that by the time inflationary risks are clear, the Fed will have to raise rates more aggressively if it wishes to staunch inflation, thereby causing a recession. On the other hand, most members of the Fed don’t want to endanger progress toward maximum employment by acting prematurely. The Fed may have some delicate decisions to make in the next year or so.

HLT: When or how will we know when inflation has returned to a normal or acceptable rate? What indicators are you watching?

Tarullo: In general, monetary policy should be forward looking. The Fed should care about inflation today only to the extent it tells us something about inflation in the next several quarters. That’s why the question of whether today’s inflation levels are transitory is so important. These days the Fed puts a lot of weight on the inflation expectations of both households and markets in trying to project what will happen to inflation in the future. To the extent that expectations are, in central bank jargon, “well anchored” around the target inflation rate, then central banks expect that inflationary or deflationary dynamics will not become embedded in the real economy. The problem is that we don’t have a very good understanding of why expectations change so, again, the challenge of real-time monetary policy decisions is a formidable one.

HLT: In many parts of the U.S. life started “returning to normal,” but this return has been interrupted as cases of the Delta variant are surging in many states. In addition, the pandemic is still raging in many parts of the world, and in many areas where vaccines are not readily available and may not be for some time. From an economic standpoint, what do you think this will mean domestically and globally in the years to come?

Tarullo: These are better questions for epidemiologists and public health officials than for central bankers. The economic effects associated with pandemics depend in large part on non-economic factors — rates of vaccination, the progression of virus mutations, and the relative willingness of governments and citizens to accept higher levels of mortality and morbidity in exchange for fewer restrictions on economic and social activity.

HLT: Have you ever seen anything like this before? What actions did the Federal Reserve take in those instances, and what lessons do they provide?

Tarullo: On this scale, no one has. In terms of economic impact, the onset of COVID had a form similar to that of a hurricane or earthquake, in that an economy totally shuts down virtually overnight for reasons outside the economy. But COVID was global rather than highly localized. And, unlike a hurricane, it was persistent. With most natural disasters, recovery starts almost immediately — rebuilding, repairing, and replacing lost possessions — usually with assistance from outside the affected area. With COVID, mandated and voluntary withdrawals from economic activity lasted months. As you noted, in many parts of the world, the disease is still largely unchecked. Even in the United States, it seems as though we may have continuing, though far less widespread, effects for some time to come. The Fed can help mitigate the damage that results, but even the most innovative monetary policy imaginable can’t keep the economy growing if people can’t work and shop because of government or private restrictions on business, because they’re ill or fear becoming seriously ill, or because they need to stay home to take care of their kids.