(Bloomberg) -- Nobel laureate in economics Paul Krugman said the biggest near-term risk to the US economy is the Federal Reserve tightening policy too much as it moves against inflation.
“The biggest risk is that the Fed will overdo it and it will slam on the brakes too hard,” Krugman, a City University of New York professor, said in an interview with Bloomberg Radio. He also said he worries that the European Central Bank is already moving too quickly to tighten.
Interest-rate futures indicate traders are betting Fed Chair Jerome Powell and his colleagues will raise their benchmark interest rate to 3.5% by early next year. The current target range is 1.5% to 1.75%.
“My guess is that the markets are probably overstating how much the Fed is going to raise rates,” Krugman said. “We’re probably going to be seeing -- just as inflation went up faster than people thought it would as the economy overheated -- inflation probably come down faster than people thought it would as the economy cools off.”
Krugman noted that he was among those who misjudged the situation last year in terms of how fiscal and monetary policy would fuel an overheated economy. Consumer prices in recent months have been climbing in excess of 8% at a year-on-year rate.
Recession Risk
“Most of the inflation we’re seeing is special factors that will go away -- Russia won’t invade Ukraine every month,” he said. “But there’s a good, solid extra maybe 2 points of inflation, excess inflation, that result from an overheating economy.”
It’s not fundamentally difficult to address that overheating-related excess, Krugman said. “It needn’t even involve a recession -- just a little bit of an uptick in the unemployment rate.” He said the jobless rate, now at 3.6%, likely has to climb above 4%.
But the challenge for policy makers is that they don’t know exactly how much interest rates need to rise to accomplish the task, the economist said. “So the chance of overdoing it, of slamming the brakes a little too hard and causing a bit of a skid is definitely there.”
A scenario in which the Fed “bobbles the thing badly enough” could send the jobless rate briefly above 5%, he said.
As for the situation in Europe, Krugman said that expectations embedded in financial markets indicate that “de facto, the ECB is pursuing a tighter monetary policy than the Fed is.” He added, “that seems to me to be crazy,” given that the euro region has lower underlying inflation and wage gains than in the US.
“My concern is actually that the ECB is way ahead of the curve and that they’re going to do what historically the ECB has tended to do, which is to over-contract” with monetary policy, he said.
©2022 Bloomberg L.P.
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