Nobel laureate Paul Krugman warns the Fed risks going too far in fighting inflation - and predicts a return to rock-bottom interest rates

paul krugman
Paul Krugman.Jeff Zelevansky/Getty Images
  • Paul Krugman fears the Federal Reserve may go overboard in fighting inflation.

  • He noted rate hikes have a delayed impact, and highlighted signs of a cooling labor market.

  • The economist predicted rates would eventually return to near zero without causing inflation.

Paul Krugman has warned the Federal Reserve is at risk of going too far in fighting inflation, causing unnecessary economic damage. The Nobel Prize-winning economist has also predicted an eventual return to near-zero interest rates once price increases are brought under control.

The Fed may have done enough

"I don't think many people appreciate how fast the economy — both labor markets and inflation — may be turning," Krugman said in a Twitter thread on Wednesday.

The economist noted that monetary tightening effectively began early this year, when long-term interest rates rose in anticipation of the Fed hiking rates. The US central bank has raised rates from near zero to a range of 3% to 3.25% since then, and signaled it could hike them to over 4.5% in the spring.

Given long-term rates have a delayed effect, the US economy is "just at the beginning of a large Fed-induced cooling/contraction," Krugman said.

The Nobel laureate also highlighted employment data released on Tuesday, which showed a sharp decline in the ratio of US job openings to the labor force to 1.7-to-1 in August. Openings were outstripping the number of available workers by two-to-one, driving up wages and intensifying inflation pressures.

Krugman argued the data was clear evidence of a cooling economy, and noted that two further monthly declines of the same scale would return that ratio to pre-pandemic levels.

"This was the best economic news I've seen for a long time," the economist tweeted Tuesday.

He said that given the lagging effect of higher rates, and evidence of a weaker job market that could relieve upward pressure on wages, there's a significant risk of the central bank going overboard in curbing price increases.

"Yes, the Fed was behind the curve on rising inflation," Krugman tweeted. "But I worry that we may be enacting the old joke about the driver who runs over a pedestrian, then tries to fix it by backing up — and runs over the guy a second time."

Rock-bottom rates could return

Krugman, in a New York Times column on Tuesday, predicted interest rates would return to virtually nothing once the inflation fight is over.

The economist highlighted that rates drifted towards zero over the course of the three decades leading up to the pandemic, but that didn't result in serious inflation.

He suggested the "natural rate of interest" may have dropped due to lower investment demand, reflecting tepid growth in the US workforce and a dearth of innovations since the 1990s. Those trends potentially weighed on investment in homes, appliances, office space, and new equipment, he said.

Meanwhile, Krugman argued that inflation only spiked during the pandemic because government aid shored up consumers' purchasing power. Meanwhile, lockdowns and supply-chain disruptions curtailed the economy's productive capacity, pushing up prices.

He suggested those two forces would prove temporary, and therefore rates would eventually return to pre-pandemic levels without causing meaningful inflation.

"It's hard to see anything that will cause the natural rate to rise once the inflation spike is over," he said. "So the era of low interest rates probably isn't over after all."

Read the original article on Business Insider