We know what happens when the Fed “looks through” one-off price hikes

Many politicians and financial analyst types are suggesting that the Fed should “look through” tariff-induced price hikes. Superficially this makes sense, because a one-time cost increase is not the same thing as inflation. Unfortunately, we know that the results are bad.

The example I’m thinking of is the price shock from much higher oil prices due to the 1973 OPEC oil embargo. As that price shock moved through the economy, first oil prices went up, then gasoline prices went up, but very shortly all prices moved up, because every business faced higher energy costs, and needed to pass at least a fraction of them forward. And then, of course, all the businesses that bought things from those businesses needed to raise their prices further, and workers started demanding higher wages because their costs were going up.

The Federal Reserve tried to “look through” that price shock, not raising interest rates, even though prices were rising. As I say, this makes sense. The one-time price shock will move through the economy, raising many prices by various amounts (depending on how much the inputs for each particular item increase in cost, and the market constraints on price increases for each particular item). Once that all works through the economy, the prices increases should stop.

In fact, raising interest rates could easily make things worse, because the cost of credit is another cost to nearly all businesses, so it’s just another expense that they have to pass on, and it’s a cost to employees, that they’ll want to recover in wage negotiations.

But we know what happened: Inflation rose enough that the Fed eventually decided that it needed to raise interest rates. Higher interest rates hurt the economy, threatening to produce a recession. The Fed cut interest rates to head off the threatened recession, which led to inflation, which led to the Fed raising rates again, etc.

The result was the stagflation of the 1970s, which only ended when new Fed chairman Paul Volker raised rates high enough to produce a severe recession, and then kept them high for long enough to wring the inflation out of the economy.

To me it’s clear that “looking through” the “one-time” price shock of higher tariffs will produce the same result. The Fed can probably mitigate it by holding rates at their current levels until the price shock works its way through the economy (which will probably take a least a year, because many prices (wages, rents, etc.) are only renegotiated annually), and only cut rates after price increases settle back down to close to the Fed’s 2% target.

I assume the Fed governors know this. Do they have the courage to take the right action? Only time will tell.