To a remarkable degree, the economy is doing just what we want it to do. The Thursday report on the Personal Consumption Index, the Fed’s preferred measure of inflation, showed prices increasing at just 0.2 percent in July, for an annual inflation rate of 2.4 percent, very close to the Fed’s own 2 percent target.

The Friday jobs report, meanwhile, showed that the economy is continuing to create jobs, with 187,000 added in July. The rate of job growth, though still strong, has been steadily falling, from over 300,000 a month in 2022 to under 200,000 a month in the past quarter. And the May and June numbers were revised downward sharply.

Wages have been increasing slightly faster than inflation in 2023, after two years of falling behind prices. If anything, they need to increase even faster, after a four-decade real decline.
The unemployment rate rose slightly in July, from 3.5 to 3.8 percent, mainly because labor force participation increased.

As I wrote in this broad assessment of the economy, the supposed trade-off, in which a low unemployment rate produces alarming price pressures, is not happening this time because the declining inflation rate is the result of supply chains returning to normal—a whole other variable. And some of the same Biden-era public investments that stimulate growth are also helping to restore supply, and thus to moderate prices.

It’s clear from this trend that the Fed made a huge analytical and policy mistake when they got wedded to the idea that the long-term inflation rate had to be 2 percent. The economy can do perfectly fine when inflation is in the 3 percent range, as it was during much of the postwar boom. The 2 percent number was picked out of thin air in 2012 by then-chair Ben Bernanke, and the current chair Jay Powell found it convenient to invoke the figure as a target when he went on his higher interest-rate crusade.

Just as the current economic situation defies the assumptions of standard models, there is another source of inflation that should not be the predicate for higher interest rates and macroeconomic tightening. That is the impact of global climate change.

Warming has already destroyed crops and put upward pressure on commodity prices. According to the American Farm Bureau Federation, 37 percent of U.S. farmers report plowing under crops that won’t reach harvest maturity because of extreme heat and drought.

A major research report by the European Central Bank predicts that global climate change could increase food inflation by between one and three percent per year.

Climate disasters are already raising insurance costs to homeowners and businesses. An analysis S&P Global Market Intelligence did for The Wall Street Journal found that double-digit rate increases have been approved in 31 states since the beginning of 2022.

In addition, climate investments to protect against storm surges and harden infrastructure will cost trillions of dollars. That will produce either higher utility rates, higher taxes, or increased public debt. Financing that public debt will require low interest costs, not elevated rates.

So the Fed is in a wholly unfamiliar economic landscape. It is perverse to base its policies on models that no longer describe reality, if they ever did.