The Fed no longer really targets inflation – you should care Eccles building Washington DC transformed into a branch of the Labor Dept (by the heading) (Fed and FAO Economics) The world changes. Policy changes. Approaches to science, medicine and even monetary policy may change. We think of change as coming from a period of superior knowledge or because of some new finding, but that is not always the case. Sometimes it’s just a different opinion. Monetary policy has just made a subtle shift that is going to put the economy in severe danger of more inflation. Danger! Monetary policy has long been in flux, many of the most contentious issues in monetary policy continue to be ‘contended’ instead of solved. Some just resisted. Others rely on information or processes we cannot implement because they rely on unobserved variables (like expectations). Of course, there are always issues that some feel are solved and others do not accept. And through this process, we get new approaches to monetary policy fueled by changing political and economic environments. The way we were… Under Volcker and Greenspan, inflation was licked. It was reduced, sometimes at great cost and sometimes opportunistically. But it was the center of attention. The Fed had a dual mandate, and it argued that it did the best it could to create full employment when it delivered a stable price environment. In that way, the Fed joined the dual mandate into a single objective without conflict. Monetary policy worked The great unbundling Powell unbundled the dual mandate and agreed that the Fed could try to enhance employment in the short run – danger, danger, Will Robinson – danger. Whatever anyone has told you, this is a great mistake and a huge problem and danger to the successful conduct of monetary policy. The Fed came under attack from Elizabeth Warren and others for being too preemptive in fighting inflation. This aggressive attack by Congress, the Fed’s official overseer (no Fed independence here), put Powell on his back foot, and eventually, he caved-in to demands for a new way to conduct monetary policy. New and definitely not improved. Flip-flop the Fed You may not realize it, but this change completely flip-flops Fed policy. Now, instead of inflation as the centerpiece with a price target, the Fed has a target for inflation that it keeps promising it will get to eventually. Inflation has become a long-term objective. Meanwhile, the Fed has focused its hair-trigger reaction to unemployment. Effectively, it has accepted the argument that it should accept 3% inflation in the short run. It has done so practically, not officially, while jawboning a 2% target; a level we have not seen for 40-months of days and nights. Even when unemployment was at a forty-year low (a low it had last seen 40-years ago and that had stayed in place for all of nine months) the Fed was focused on not raising rates too much and not untracking the job market. Now with inflation over target for 40-months and counting, the Fed is ready to cut rates in by September- and it’s not because inflation is its target pace. Inflation is doing better in some ways. But the Fed is motivated instead by higher unemployment; not the prospect of actual unemployment. The roles of inflation targeting and employment enhancement have been reversed. Their priorities have flip-flopped as well – and that spells danger. Powell as shadow Labor Secretary The priority the Fed seeks in the immediate term is its top priority. And now that is unemployment/full-employment/maximum-employment. The Fed has tolerated over target inflation growth for 40 months in a row. It allowed the CPI to get to 8 ½% before it lifted its pinky to hike rates. Yes, eventually the Fed clustered together 75bp hikes but that was so after-the-fact and then the Fed stopped at the earliest moment possible-with real interest based on trailing inflation at zero. Some at the Fed take the Fed’s multiple rate hikes as evidence that it has won back its credibility. But it started that hiking process so late, and now it is giving us no follow-through. The Fed engineered multiple rate hikes because it had no other choice. Through the looking glass We are now in a new world. After the Great Recession, we also were through the looking glass… Then it was a more competitive, less inflation-prone world. Now, firms have tasted the forbidden fruit of price increases. The Fed is less responsive to pushing back against that. The Fed is focused on the labor market, the breadth and equality of unemployment and employment gains. The Fed is attentive to things far beyond its control, but things that make Congress happy. Happy Congress, happy Fed! Fed independence is exaggerated Remember this; as people rant and rave about Trump saying he wants a say in Fed policy, so it has been with all Presidents. Trump is simply unabashedly outspoken. Other presidents would hide that ambition – not Donald. Ronald Reagan actually stuffed enough governors on the Fed Board to overturn Volcker and engineer a rate cut when Volcker did not want them. Congress rules – not the president The Reagan case was unusual – but impactful. The president gets to nominate Fed members and nominate the chair, but the Senate must approve. That’s it for the Oval Office. On the other hand, the Fed was created by an act of Congress and Congress has continuing oversight responsibilities. The Fed is overseen by Congress, with four Chair-given testimonies a year. And Congress tries to manipulate the Fed. It tried to get the Fed to lend less to carbon-producing corporations. It tried to get the Fed to make policy as easy as possible because it would lower unemployment for the most disadvantaged, and pushed for DEI recognition. And it can do some of this- but only temporarily, and at some cost…to everyone, including the minorities it may help. Because, excessively stimulating monetary policy is not good for the economy or anyone in it. Politics always lurk – Do not kid yourself about the Fed. There are politics afoot here. And so it has always been. The Fed has mostly steered clear or to a neutral corner, but the Fed has taken partisan actions from time-to-time. Arthur F Burns being the most memorable. The shell game – The Fed no longer has monetary aggregates M1 through M5 to confuse you with. But it has the PCE and Core PCE, and it can subtract various things out like truck prices or owner’s equivalent rent or more from its price index to create more inflation options. And then it can look at 3-month, 6-month or, 12-month inflation rates. The Fed actually has many more than five things to look at to confuse you. The Fed used to only look at year-on-year inflation, but as inflation fell sharply, the Fed shifted its policy. Why? To accommodate an easier policy! Not because it was right. The Fed always resisted doing that in the past. But now there are political pressures…winds of change. And the Fed is apolitical! Dept of interest rates and labor – We already have a department of labor. We do not need a Federal Reserve to augment the duties of the department of labor. The Fed does not have to do the job of the EPA, either. How did the Fed get pushed in those directions? Congress! Remember, Congress stepped in to help support and save Jay Powell from the evil Trump. And that is how they closed around him and eventually became influential, and Powell, after all, is a Wall Street deal-making kind of guy, not an economic ideologue. But this trade-off in the primacy of Fed policy. To favor jobs over prices is a mistake. And now, it’s a new world, part II. Back through the looking glass It’s as though we are going back to where we came from. The old world… Old constraints… Inflation risk… Less global competition… Wars – no peace dividend. Military spending needed… Supply chains pulled back from their cheapest and most risky spots… Aging populations… High debt levels… A bad combination to let inflation go – as we have been finding out. ‘Higher for longer’ (the way to a soft landing) has been expensive for government financing as well as for the US housing market. And we have two presidential candidates who want to spend. S-P-E-N-D. One wants to spend and cut taxes; the other wants to increase social welfare and hike taxes – maybe sprinkle in some prices controls. Neither is a likely case to lower inflation forces. And so the Fed, with a 40-month string of overshooting (have I mentioned that yet?), is on the brink of a rate cut. And it is not partisan! I am quite flummoxed and confused. I am not reassured. And the arrangement of Fed priorities is very confusing. It is not a neutral plan. And the day of reckoning is coming. This is a warning. It’s a real warning about how the future is going to be different and more inflationary because circumstance, focus, and determination have shifted – away from inflation vigilance and prevention. I have always said you should worry about what the Fed is not worried about. Right now – that’s inflation because the Fed is sweating the unemployment rate. Klaus Vedfelt/DigitalVision via Getty Images
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