Can the Fed curb inflation? Maintaining stable growth is harder than it looks.
About the Author: J.W. Mason is Professor of Economics at John Jay College, City University of New York and a Fellow of the Roosevelt Institute.
In today’s often acrimonious economic debates, one of the few common motives is respect for the Fed. Consider Jay Powell. First appointed to the Fed Board of Governors by President Obama, he was elevated to Chairman of the Federal Open Market Committee by President Trump and reappointed by President Biden. His predecessors Ben Bernanke, Alan Greenspan and Paul Volcker were also first nominated by a chairman of one party and then reappointed by a chairman of the other. Politics, it seems, stops at Maiden Lane.
There are disagreements about what the Fed should do. Should it tighten its policy to contain inflation or hold it back to allow a faster recovery? But few doubt that it’s the Fed’s job to make the choice, and that once they’ve made it, they can do it.
But maybe we should take a step back and ask ourselves if the Fed really is all-powerful. You might like to see inflation go down; I would like to see stronger labor markets. But can the Fed give any of us what we want?
During the so-called Great Moderation, it was easy to trust the Fed. In the United States, as in most rich countries, governments had largely entrusted the work of macroeconomic management to independent central banks and were enjoying an era of stable growth with low inflation. Magazine covers could, without irony, feature the Fed Chairman in papal regalia as “Alan Greenspan and his College of Cardinals”, or (when the waters got rougher) the central figure of the “committee to save the world”.
The respectable opinion of the 1990s and 2000s was captured in a Christina Romer speechsoon to be Obama’s chief economist, stating that “the Federal Reserve is directly responsible for the low inflation and virtual disappearance of the business cycle over the past 25 years… The history of politics stabilization of the last quarter of a century is one of incredible success.”
Romer spoke those words at the end of 2007. Almost exactly at that time, the United States was entering its deepest recession since World War II.
The housing bubble and the financial crisis raised doubts as to whether this success had been so astonishing after all. The following decade of slow growth and high unemployment, in the face of a zero fed funds rate and multiple rounds of quantitative easing, should have paid off better. Obviously, the old medicine was no longer working. Maybe it never worked as well as we thought.
In truth, there were always reasons to doubt.
The first is that, like Milton Friedman famous observed, monetary policy acts with long and variable lags. A common estimate is that the maximum impact of monetary policy changes occurs 18 to 24 months later, which is extremely slow for the management of economic cycles. The last episode of rising prices in the United States occurred in the summer of 2008, when inflation hit 5.5%. A year later, unemployment was in double digits and the United States was experiencing deflation. With the main effects of today’s tightening being felt two years from now, how confident are we that inflation will remain our primary concern?
More fundamentally, there is the question of what links monetary policy to inflation in the first place. Prices are, after all, set by private companies; if they think it makes sense to raise prices, the Fed has no mind control to convince them otherwise.
In the history of the textbook, changes in the federal funds rate are passed on to other interest rates. A higher cost of borrowing discourages investment spending, which reduces demand, employment and wages, which in turn puts downward pressure on prices. It was always a bit circuitous; today, it is not certain that the critical links in the chain are working.
Business investment is financed by long-term debt; the average maturity of a corporate bond is around 13 years. But long rates do not seem particularly sensitive to the fed funds rate. Between fall 2015 and spring 2019, for example, the Fed raised its key rate by 2.5 points. Over this same periodthe 10-year Treasury rate remained essentially unchanged and corporate bond yields actually fell. Previous episodes show a similar non-response of long rates to Fed actions.
Nor is it clear that corporate investment is particularly sensitive to interest rates, even long ones. One recent survey literature by Fed economists finds that hurdle rates for new investments “show no apparent relationship to market interest rates”.
Bernanke puzzled the “black box” of monetary policy transmission before becoming Fed Chairman. If this does not change interest rates on the long-term debt that corporations primarily issue, and if even longer rates have no detectable effect on investment, how exactly does monetary policy affect demand and inflation? It was a good question, to which no one offered a very good answer.
Certainly, no one would argue that the Fed is powerless. Raise rates enough and borrowers unable to renew their loans will face default; as asset values fall and balance sheets weaken, households will have no choice but to drastically reduce their consumption.
But being able to sink a ship is not the same as being able to steer it. The fact that the Fed can, if it tries hard enough, trigger a recession, does not mean that it can maintain steady growth. Maybe it’s time to admit there is no central bank “masters” who know the secret of maintaining full employment and price stability. Balancing these critical social goals requires a variety of tools, not just a single interest rate. And that is, for better or worse, the responsibility of our elected government.
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