Powell should remain cautious to avoid further economic turmoil
Last week the New York Times
Strain wants the Fed to become more aggressive “immediately”, which is contrary to the approach that I have been promoting for months. The aggressive tightening right now ignores that supply issues are a main driver of the recent CPI surge. Tighter monetary policy in the face of these supply shocks means that people will have even less funds to buy even scarcer goods.
It’s a recipe for disaster, but Strain makes no mention of this problem.
Yes, a good deal can be done that the Fed should start signage that it will soon tighten. And I even argued that the Fed should gently tighten end of 2021 or beginning of 2022 on condition that Nominal GDP (GNPD) remains on its current path. (It’s roughly return to its pre-pandemic trend now and seems to be increasing.)
But assuming that the Fed can aggressively tighten now without causing major economic problems, resulting in nothing more than avoiding a future recession, gives the Fed way too much credit. This idea dates back to the time when naively federal bureaucrats thought they could ‘fine tune’ the economy permanently reach a high employment rate, stable prices, higher productivity and better standards of living. (Some people maybe hold on to this dream, but the rest of us are living in reality.)
Given that bad taxation and regulatory policies undeniably increase inflationary pressures (and contribute to people who remain outside the labor force), Strain’s proposal amounts to calling for a duel of economic policies at the federal level. Against the backdrop of congresses and administration harmful implementation policies that increase specific prices, he wants the Fed to use a restrictive monetary policy so that the overall price level will fall.
The craziness of this approach is evident in multiple segments of the economy, including housing. For example, Strain wants the Fed to stop buying Fannie / Freddie mortgage-backed securities, a very sane idea that would at least relieve some price pressure in the “”white-heated housing market. “But even if the Fed stopped buying these securities, the pricing pressures would move in the opposite direction to those of the Biden administration’s policy of double a punitive sales tax on US buyers of Canadian lumber.
Furthermore, if history is any guide, it is wishful thinking that the Fed can precisely offset the recent surge in the CPI, let alone counter price increases in specific product categories, like the wood, beef and poultry. (Remember that the Fed spent the last two decades consistently undershoot his inflation target, even when there was no kind of economic crisis.)
There are also at least three general issues that Strain’s policy recommendation shares with university economics:
- He credits the Fed for keeping interest rates low, “thus making the economy run so hot.”
- He calls on the Fed to weigh price stability against maximum employment.
- He assumes that the Fed should seek price stability.
First, Fed officials cannot simply make interest rates whatever they want them to be. In fact, it should be indisputable that the Fed cannot even maintain (for example) the fed funds rate (for example) it wants, especially at a level inconsistent with the (natural) equilibrium rate under- behind federal funds. If, for example, the Fed tries to maintain an abnormally high federal funds rate (a rate above the natural rate), this will lead to an excessively restrictive monetary policy. Everything else constant, lending, overall spending, and the price level, will go down, and the drop in demand for credit will cause the federal funds rate to drop.
Second, even though the Fed has a mandate of Congress which obliges him to “Effectively promote the objectives of maximum employment, stable prices and moderate long-term interest rates”, it largely does justice to the employment part of the directive because it must. Officially, the Fed recognizes that “The maximum level of employment is largely determined by non-monetary factors that affect the structure and dynamics of the labor market”.
Finally, despite its mandate to promote price stability, it would be much better if the Fed has targeted growth in total nominal spending instead of inflation, thus striving to maintain a neutral monetary policy. In the face of supply-driven economic changes, a central bank that targets inflation always opposes natural market forces that drive price changes.
- When there is a positive supply shock, such as an increase in productivity, prices should fall, allowing people to enjoy the benefits of more goods to sell at lower prices. This type of deflation is not the enemy, and a growing economy does not automatically lead to higher prices. Yet the central bank that targets inflation is trying to raise prices.
- In the face of a negative supply shock, such as a significant trade slowdown, prices are expected to rise as goods and services become scarce. These price increases signal companies to provide more goods and services. Tighter monetary policy could reduce the headline inflation rate, but it will not lead to an increase in the abundance of goods and services. It could even lead to more serious shortages. Yet the central bank that targets inflation is trying to lower prices.
Sound economic policy requires that any barriers leading to specific higher prices be addressed directly. Sound monetary policy forces the Fed to tolerate a higher price point provided that the inflation rate does not continue to climb and push the PDNG too far. In today’s economy, this policy prescription amounts to (1) ensuring that the PNDG does not overshoot its pre-pandemic trend; and, (2) remove political barriers that exacerbate supply shocks related to COVID-19, including restrictive labor, immigration and trade policies.
Strain is right to say that “Mr. Powell now faces a very different economy from the one he had when he took over as the Fed in 2018.” So there is good reason to believe that tightening or loosening monetary policy to stabilize prices – the same basic policy prescription we’ve heard over the past half century – might not be the right approach.