Still Flying Blind after All These Years
(i) Sarrera gisa
The Federal Reserve’s Continuing Experiments with Unobservables
Institute President Dimitri B. Papadimitriou and Senior Scholar L. Randall Wray contend that the prevailing approach to monetary policy and inflation is influenced by a set of concepts that are a poor guide to action. In this policy brief, they examine two previous cases in which the Federal Reserve misread the data and raised rates too soon, as well as the evolution of the Fed’s thought and practice over the past three decades—a period in which the central bank has increasingly turned to unobservable indicators that are supposed to predict inflation. Noting that their criticisms have now been raised by the Fed’s own members and research staff, the authors highlight the ways in which we need to rethink our overall framework for monetary and fiscal policy. The Fed has far less control over inflation than is presumed, they argue, and, at worst, might have the whole inflation-fighting strategy backwards. Managing inflation, they conclude, should not be left entirely in the hands of central banks.
Download: Public Policy Brief No. 156
(ii) Politika fiskala eta politika monetarioa
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Toward a Better Mix of Fiscal and Monetary Policy
In conclusion, control over the fed funds rate probably gives the Fed less control over spending and inflation than typically presumed, and it might not even move spending in the direction desired. In any event, the experience of the past two decades has raised the possibility that the Fed’s policy is less potent than previously believed. At the very least, we need to consider putting more responsibility on fiscal policy for maintaining aggregate demand with reasonably constrained inflation and high employment. Fiscal policy has more tools—including the conventional tools of spending and taxing.
Congress also has tools that go beyond usual fiscal policy. It has used trade policy, regulations, wage and price controls, subsidies, and even rationing to fight past inflation. It can also release commodity buffer stocks (as President Biden has done in the case of oil) to reduce price pressures. Further, fiscal policy can be targeted in a way that monetary policy cannot: the Fed can raise or lower the fed funds rate, but it is difficult to use that to focus the impact on a region of the country or a particular kind of activity. Fiscal policy also can be used directly to promote building capacity to relieve price pressure. While the Fed can use nonconventional monetary policy to direct credit to particular groups (buying mortgage-backed securities to support home lending, buying municipal bonds to support local government), this presents two kinds of problems. The first is the “you can lead a horse to water, but you cannot make her drink” sort of problem: the Fed still needs willing lenders and borrowers, both of which are hard to find in a slump. The second is that the Fed is a chosen body of experts that does not face reelection, not a democratic body representing the interests of the electorate. To the degree that we are going to use targeted policy, we are picking winners and losers, and that job is better left to our elected representatives. The current dilemma in which we find ourselves brings into sharp focus the danger of relying on monetary policy to deal with inflation. The global pandemic severely disrupted global supply chains. What began as a supply-side shock morphed into a demand-side problem as incomes fell because people could not go to work, and many service-sector firms (especially) had to shut their doors. Complicated supply chains plus just-in-time production led to shortages of key components so that even with huge spending by the fiscal authorities to replace lost income from work, recovery of production has been constrained. As a result, prices are rising more rapidly than they have for years. So far, the Fed has been remarkably and admirably patient, insisting that the causes of the price hikes will fade away. However, these “transitory” conditions are stretching into many months and pressure is building on the Fed to “do something” before inflation expectations become unanchored.
Yet, raising rates now would be the wrong response, especially if one believes that the interest elasticity of spending is high. Fighting the combination of slow growth and high inflation with higher interest rates would not help to restore the supply side of the economy. The correct response would be to increase spending on the supply side to relieve shortages— which will require finance. Raising rates would raise the cost of finance. If the conventional views of interest rate effects are correct, it would be bad policy to raise rates when the supply side is struggling.
In any case, ramping up capacity in key areas is something fiscal policy is better equipped to do. For example, one of the bottlenecks has been insufficient capacity at the nation’s docks for unloading container ships. We need to quickly restore and increase capacity—requiring both private and public spending. This is also the right time to begin to build alternatives to fossil fuels (shortages of which are driving up prices) and alternatives to stretched supply chains that were always vulnerable to disruption due to weather, earthquakes, and war. It is certainly true that all of this transition will take time—but the time to start is now. And if monetary policy is to play any role, low rates would be more conducive to capacity building.
We are reminded of the misguided response to the oil price shocks of the early and late 1970s. These sparked high inflation in both cases, along with high unemployment—what was called stagflation. And in both cases the policy response was austerity—precisely the wrong response, as it increased unemployment sharply. The correct response then, and now, is to become more energy efficient and to promote alternative energy sources. Not only would that have avoided prolonged stagnation in the 1970s, it would also have reduced reliance on oil—an energy source that comes from regions of the world that are politically unstable and that was recognized even at the time as environmentally damaging. Today we realize that we have no choice: we must stop using fossil fuels. But the point we are making here is that austerity policy is not the right choice when inflation is coming from problems on the supply side.
The nation’s GDP has not yet recovered to its pre-pandemic peak, which indicates that our problem today is not one of a general excess of demand—we have unused capacity in the form of unemployed labor and capital. It makes no sense to tackle inflation through a policy that is designed to reduce demand across the board. We need a targeted response, and as discussed, monetary policy is not appropriate for that task. The problem is very complex—it is still not safe to fully reopen the economy, and in any event, the US relies on imports of essential components, so full recovery of our economy will require either global recovery or developing domestic sources. Raising rates to produce a domestic downturn is not helpful.
Further, even if we believed that the problem is too much demand, the solution would be for fiscal policy to tighten— since it is the pandemic’s fiscal response that has been sustaining demand in the face of huge supply-side headwinds. We are not calling for this, even though we would have preferred a more targeted fiscal response to the pandemic. The best approach now is to do what we can to support the supply side of the economy—which includes getting people back to work safely.
We are asked to believe that the Fed can and does control inflaion by anchoring long-term inflation expectations. Further, we are asked to believe that this is a proper role for the Fed and that low inflation should be a high priority—if not the highest. To some extent, this is even mandated by Congress, although the Fed is left to its own devices in choosing its policy tools as well as its target inflation rate.
The low inflation rates of the past quarter century are taken as evidence that the Fed has successfully achieved its goal—albeit perhaps a bit too well over the past decade, as inflation has been persistently below target. We have argued that this claim cannot be proven or disproven by the evidence. (…)
We think it is time to put to rest policy that is overly focused on unobservables. If the Fed is going to be tasked with fighting inflation, it ought to include those variables that are both observable and can be shown to be linked to inflation. This is similar to the conclusion reached by two Fed insiders—Rudd and Tarullo. It might also be time to reexamine our reliance on the Fed as the primary inflation fighter. The Fed cannot do much about supply-side driven inflation—which, arguably, was our problem in both of the high inflation periods in the 1970s as well as the problem we face now in recovery from the pandemic. And, we think, it is also time to question the link between the fed funds rate and inflation. Indeed, we suspect that part of the reason the Fed and the NMC [New Monetary Consensus] have highlighted an unobservable is because the evidence for the interest rate–inflation link is not strong, and may even run in the wrong direction.
We do believe the Fed plays an important role in the economy, and it should focus on those matters over which it can have significant influence. The Fed has demonstrated its ability to come to the rescue when we need a lender of last resort. The Fed keeps our payments system functioning even when severe financial crisis hits. Both are worthy accomplishments. The Fed is the Treasury’s bank and ensures government checks do not bounce and that interest on Treasury bonds gets paid in a timely manner. The Fed also plays a role in regulation and supervision of financial institutions—there its record may not be so stellar. For example, the Fed was given broad authority to regulate
mortgage lending, and its performance was not very good during the run-up to the GFC. This is an area in which greater focusby the Fed might be called for.
Economists and the Fed should put less emphasis on ephemeral expectations—particularly for policy purposes. We would also like them to consider the joint possibility that monetary policy has little impact on real world inflation, and that the high inflation we experienced 40 years ago is unlikely to
return in the near future. Further, more focus should be placed on price pressures that come from the supply side—outside of major wars, the demand side is not the main culprit. Finally, fiscal policy might be better suited to inflation fighting, whether it comes from the demand side or the supply side.
