In more and more assessments, the current increase in US inflation is being blamed directly on the Federal Reserve. However, much of the criticism is startlingly naive about the political pressures that the Fed and other central banks have faced in recent years.
In the United States, pressure on the Federal Reserve came to a head when Democrats, eager to implement progressive ideas, took control of the White House and Congress in January 2021. Yes, the Fed is very independent in many ways, but it does not have nearly the same institutional autonomy as, for example Example, the European Central Bank.
Instead, the Federal Reserve is a creation of a Congress that could, in theory, be radically reshaped in the short term. Importantly, the term of a Fed chair always ends one year after the new president takes office, and President Joe Biden’s administration has been able to make several more Fed appointments. Although the idea of “Fed Mobilization” (adding new positions to overturn a central bank voting majority) hasn’t gained any traction, Fed officials certainly heard the Biden administration’s debate over whether to support a conservative majority of the US Supreme Court. This must be countered by increasing the number of judges.
Resistance from Washington and academics
Given Biden’s attempt to provide massive fiscal stimulus, how realistic is the Fed to start raising interest rates in the first half of 2021, when inflation is starting to pick up? Most economists have not yet considered inflation a major macroeconomic problem. When my Harvard colleague, Lawrence Summers, began warning about inflation in February 2021, not many economists were taking lasting recovery from the Covid pandemic for granted.
In addition, progressives were excited by the idea that US government debt could increase dramatically without a significant increase in inflation or interest rates. Modern Monetary Theory (MMT), an extreme version of this idea, which envisions the Federal Reserve buying debt as the Treasury issues it, has had many influential proponents in politics and the media. As recently as February 2022, when annual inflation in the US was 7.9%, the New York Times published an impressive dossier on MMT advocate Stephanie Kelton.
Had the Fed started raising interest rates by a quarter or half a percentage point in the first half of 2021, the Biden administration would have ensured that the central bank was responsible for any subsequent decline; MMT proponents said their experience never really got a chance.
Cool idea “helicopter money”
This would have been a very effective criticism of the Fed given how long inflation has been stagnant. Before the pandemic, inflation seemed to have disappeared except for some extremes such as Argentina and Venezuela. At the same time, many governments have been encouraged by low interest rates to dramatically increase their budget deficits.
Acclaimed centrist economists such as Olivier Blanchard (International Monetary Fund) have argued that governments should worry less about debt than in the past as interest rates will remain too low relative to GDP growth rates. Others stressed that governments should allow debt to rise in recessions and crises, but care less about effectively reducing it in boom times. It seems that inflation was not a big problem.
In fact, so-called helicopter money, that is, central bank financing of budget deficits, was widely promoted as a means of stimulating the economy when monetary policy makers were unable to lower interest rates, which were already close to zero. Although some of us argued emphatically that methadone maintenance therapy and even its softer variants were wildly misleading, it was a tempting idea and until inflation got out of hand, its weaknesses were difficult to conclusively prove. In a way, the Biden administration’s experience with excessive stimulus in a growing economy was one that had to be tried, and progressives would have targeted the Federal Reserve if it got in the way.
Markets against raising interest rates
While this may explain why the Fed didn’t raise interest rates initially, why is it still refusing to act when inflation accelerated in late 2021? Part of the explanation may be that Fed economists really believe that inflationary pressures are temporary. But Biden’s decision to delay the reappointment of Fed Chairman Jerome Powell until the end of November also played an important role. Had the Fed started raising rates in the second half of 2021, Biden would most likely have replaced Powell with a more pessimistic person, and markets would have refused to raise rates immediately.
Is there a way the Fed can better protect itself from such pressures in the future? Accuse the central bank of not taking the idea of a long-term negative interest rate policy as a means of deflation mitigation seriously in 2019. To be fair, it must be said that economists have also lagged behind in this regard. Much of the intellectual resistance to significantly negative interest rates is strangely superficial and needs to be addressed in the next Fed policy review.
Full effect only after quarters
If the Fed had a more effective tool to fight deflation, it might have been bolder to raise interest rates earlier than inflation would rise. It usually takes a few quarters to show the full impact of monetary policy on inflation, and the Fed needs confidence to be more flexible.
In general, the Fed has its share of the blame for the hyperinflation of the 1920s. But strong political pressure from the left and over-optimistic analyzes of permanent debt policy as well as genuine doubts regarding inflation and real interest rates also played a major role.
Copyright: Project Syndicate.
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