The Fed is not powerless | AER

In a recent article on Axios, Neil Irwin asks. why raising the interest rate has not tamed inflation. Inflation remains high despite eight Fed rate hikes in the past year. The latest Personal Consumption Price Index (PCEPI) data shows that the price level rose 0.6% in January, up 7.2% year on year.

“Something weird is going on when the Fed can tighten policy so much to achieve so little in terms of demand reduction,” Irwin writes. This “raises important questions about the Fed’s ability to achieve its price stability goals.”

However, dig a little deeper and the mystery is not so mysterious. The Fed didn’t run out of ammo – far from it. Continued inflation is the result of an increase in aggregate demand. The interest rate hike hasn’t stopped him yet, because monetary policy hasn’t been all that tight.

It is strange to worry about the impotence of the Fed among biggest jump in aggregate demand in a generation. Nominal GDP (total spending at current market prices) has not only grown, but is growing much faster than before. Aggregate demand of $26 trillion is somewhere between 3% and 8% above pre-pandemic growth. What caused the jump? Emergency monetary policy, of course! The Fed has plenty of ammo, as we’ve learned the hard way.

Irwin writes that today’s robust inflation is a “mirror image” of the persistently low inflation of the 2010s. But the Fed’s failure to create inflation in 2008-2020 and its failure to bring inflation down today are only apparent. Monetary policy during this period was tighter than Irwin and others suggest.

After the 2008 crisis, the Fed significantly expanded its balance sheet, which led to an explosive growth in bank reserves. But he also paid banks to refuse loans by offering interest on reserve balances. If the Fed gives me $3 trillion reserves and I bury it in my yard, guess what happens to aggregate demand? Almost nothing. The same thing happens if new liquidity sits idle in bank vaults.

In the next snippet Irwin and collaborator Courtney Brown acknowledge Readers’ comments suggest that it could take 6 to 12 months for monetary policy to affect the economy. But monetary policy’s “long and variable lags” caution is exaggerated. This greatly understates the power of expectations. Although it is fashionable in some circles to dismiss the importance of expected inflation in determining actual inflation, the alternative theories are worse. They require economic actors to be completely myopic or predictably exploitable. In reality, how Scott Sumner claimscredible monetary policy has an immediate impact on expectations and therefore can shake up the economy right away.

We know the Fed has credibility problem. Based on comments by Chairman Powell and other FOMC members, it appears that the Fed’s 2 percent “average” inflation target is asymmetric. The central bank will tolerate inflation above 2% but does not want to tolerate inflation below 2%. There is a basic arithmetic problem here: 2 percent cannot be a long-term average inflation rate if the Fed is asymmetrically targeting 2 percent.

The markets have noticed. inflation expectations are crept up in recent weeks. Markets for goods, services and financial instruments continue to operate in a high inflation environment simply because the Fed is not giving credible signals to the contrary. Inflation expectations still matter.

The most important thing the Fed can do to restore lost confidence is to continue tightening. Assuming the natural interest rate is in the range of 0.25 to 0.5 percent, the target federal funds rate should be between 7.45 and 7.70 percent today. The balance sheet should continue to shrink as assets mature and the Fed refrains from buying new ones. Equally important, the Fed should stop distracting yourself with irrelevant policy questions such as CALL and climate change. The Fed can convince the markets that this is serious business if it takes these steps.

The Fed has a tank full of gas. If he sticks to proven monetary policy strategies, he can bring down inflation. However, if he continues his destructive and misguided innovations, price pressures will continue to torment us for some time to come. Responsible monetary policy researchers must vigorously confront the myth of a “powerless Fed.” All it does is remove the responsibility from central banks for what, based on good theory and a growing body of evidence, is their fault in the first place.