A new strategy to fight inflation
This is a WSJ op ed, written about the Fed’s strategy review. Now that 30 days have passed, I can post here. For fun, I post here the version I sent to WSJ. You can decide whether their edits at the link (which did cut the word count) are better or wore than the original.
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The Federal Reserve is readying a new strategy, while debating what to do about tariffs. On Wednesday, the Fed announced no change in interest rate, noting rising stagflationary risks to both inflation and unemployment. But the big challenges lie ahead. What will emerge from the conclave?
Rethinking is appropriate. The Fed’s central task is inflation. Inflation peaked at 9% in June 2022 and hasn’t hit the Fed’s 2% target since February 2021. In the wake of such a basic failure, a healthy institution should should do some profound soul-searching. The previous “flexible average inflation targeting” strategy was a beautifully constructed Maginot line against the Fed’s fear of deflation at zero interest rates. That is clearly not today’s problem.
Why inflation surged is not hard to divine. The government, including Fed, Congress, and Treasury, met the pandemic with a river of money. The government borrowed and spent $5 trillion in 2020, mostly sending checks to people and businesses. The Fed helped, by swiftly creating about $3 trillion, buying bonds and thus giving the Treasury money to spend. The Fed directly lent additional money, propped up asset prices, and kept interest rates down. No wonder inflation broke out.
This is not a new story. It is the standard package of war finance: In an existential crisis, spend like crazy, borrow and print money to do it, hold interest rates down. Inflation is part of the package: it is essentially a wealth tax on bondholders to finance the spending. A spurt of inflation has followed every US war from the Revolution on.
As in the past, the key decision to repay or inflate away debt came after the war. After Covid was largely over and with the economy swiftly recovering in 2021, the government went on an additional unrelated spending binge. The Fed kept rates at zero for a full additional year, slower than it has ever reacted to inflation. Inflation it was.
The Fed blames “supply” and “relative demand” shocks for inflation. But such shocks do not by themselves cause inflation. The Covid-era shocks made Pelotons more expensive than wages or restaurant dinners. But why did everything go up? Only because the Fed and Treasury gave people enough extra money to pay higher prices all around. They feared that any price or wage declines would cause a recession.
This “supply shock accommodation” story is also well known. In the standard analysis, the 1970s oil shocks did not directly cause inflation. The Fed chose more inflation to obtain a bit less stagnation.
The recent inflation was a choice, made in difficult circumstances. An honest Fed and government would say, “We thought we faced a calamity. We met it with the classic tools of war finance, including inflation so bondholders would pay most of the bill. We faced huge supply shocks. We met them with inflation to avoid a severe recession. You’re welcome.” That they do not do so suggests a certain regret about choices.
The Fed will have to make hard choices again. There will be crises. Tariffs and trade war, if not swiftly abandoned, will be another stagflationary “supply” shock, raising prices while reducing the economy’s productive capacity. The Fed will face an unhappy choice between more inflation and somewhat less contraction. It will be harder because lower interest rates do little to goose an economy suffering a supply shock, by the large political, institutional, budgetary, and financial repercussions of higher rates, and by once-burned twice-shy inflation-skittish markets. For an unprepared Fed, promptly raising rates to combat inflation will be nearly impossible.
So far, there is little sign that the Fed acknowledges the need for hard choices and fundamental reform, preferring instead to focus on “communication” and “managing expectations.”
What should the Fed do?
The Fed defined “price stability” as 2% inflation, on a forward-looking basis, ignoring any past mistakes. Easing voices want the Fed to again “look through” another price level increase that is not forecast to produce continuing inflation. But people are really mad about higher prices, even though “transitory” inflation has faded. Don’t do that again.
In the last review, the Fed committed to make up undershoots with more inflation to bring prices back. The Fed should make that symmetric: Promise now to make up any overshoots with lower inflation, to gently bring back the level of prices. Confidence in lower prices ahead can restrain inflation now.
Additionally:
Use independence. The Fed can say no to buying trillions of Treasury debt, to holding down interest rates, to financing Treasury handouts, to lower rates in order to weaken the dollar.
Distrust forecasts. They were dramatically wrong before and will be wrong again.
But react quickly to inflation when it breaks out. No more waiting for “transitory” inflation to disappear. Promise quick “data dependent” reaction, not a fixed path for rates.
Tolerate relative price movements. Some prices and wages going down when others go up is not the end of the world, requiring a perpetual inflationary bias.
Remove the financial hostage. Higher interest rates or a recession threaten banks again, and another bailout. Get interest rate exposure and huge leverage out of the financial system.
The Fed cannot control inflation alone. If the rest of the government wishes to avoid a repeated inflation (and its electoral consequences) in the next crisis. it should
Forswear stimulus. Everyone can see the Covid and post-Covid spending was overdone. Prepare to spend wisely, on measures that clearly and narrowly address the crisis at hand.
Restore fiscal space. To borrow in a crisis, without driving up interest rates or inducing inflation, the government needs to assure investors that additional borrowing can and will be paid back by tax revenues or spending cuts. Tax, spending, and growth reform buy good credit.
Borrow long. If the Fed raises rates, interest costs on the debt rise. That adds to the deficit and can boost inflation. Move the treasury to long-term borrowing, and coordinate with the Fed not to throw away that insurance with bond purchases.
Only planning now can avoid a larger surge of inflation when the next “shock” or crisis hits.
John H. Cochrane is a Senior Fellow of the Hoover Institution at Stanford University, Adjunct Scholar of the CATO Institute, and author of “The Fiscal Theory of The Price Level,” Princeton University Press.
References:
Current strategy:
https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf
Strategy review research conference:
https://www.federalreserve.gov/conferences/second-thomas-laubach-research-conference.htm
The WSJ version is an improvement over the original version submitted for publication. Normative statements, typical of the writing of economists, are replaced by positive statements. Other changes improve readability, correct factual errors, and condense paragraphs, all with a view to increasing reader comprehension of the author's essential original thoughts.
In sum, this is an example of English Grammer 401 meeting the technical wizard's stream of consciousness. It does happen quite alot of the time, and it fully demonstrates the advantages of a formal Fine Arts post-secondary school education. Where the technical wizard excels in analyses of physical and/or economic systems and the application and control of the same to solve important issues relating to production, utilization, and the financing and control relating to the management thereof, the English major is vital to the communication and comprehension of the technical wizard's wizardry by the generalist manager and the users and customers of the technical innovations in everyday life. Embrace it.
One must believe that the money printing post Covid was for recession prevention. This is a difficult argument to defend when the economy was in recovery mode already. It is easier and likely more accurate to support the ideology of progressive Democrat politics as a spending motivator. What we got in return was a phenomenal increase in the growth of government, not so much the private sector. Astronomical amounts of money were wasted; the private sector economy stagnated other than politically favored industries (climate change). Energy, still the life blood of any thriving economy, became a major issue in itself as well as contributing to increasing prices. Energy was a 100% politically driven self-inflicted factor.
Not to have consequential influence on our trade balances with obsessive scrutiny of the relationships with our trading partners must have future consequences to America, none of which can be imagined to be positive. "Business as usual" is not a solution to anything including economics, security and the balance of power in a world far from a Kum By Yah landscape. One can have opinions on how the issue of trade policy as it effects virtually everything can be addressed, but criticism without defensible alternatives to the role of tariffs in their economic, political and negotiating value is unacceptable.
The FED is political. The market is less so. I would continue to trust the collective wisdom of millions versus the that of a few who, given the fact they are human, will have biases, blind spots and political alignment.