The Fed has failed to keep inflation low despite being independent and having an inflation targeting goal since the eaighties, it might need to reinvent itself to avoid becoming the target of establishment-bashing populists.
The US central bank, the Federal Reserve (Fed), has had quite the reversal of fortune as of late. Usually central banks are the high temples of technocrats, where the world’s most accomplished economists make the hard decisions politicians can’t. After the inflationary period in the 1970’s central banks were given more independence and inflation targets which have led to a generation of stable and low inflation in stark contrast to how things were in the 60’s and 70’s. The Fed was seen as the cream of the crop, the most important central bank which had managed not only to stabilise inflation in the 80’s but dealing with the crises of 2008 and 2011. When the Bank of Japan was fighting deflation tooth and nail, and the European Central Bank’s then president Mario Draghi had to promise to do ‘whatever it takes’ to keep the Euro from collapsing, the Fed was keeping America stable. In the summer of 2021 though things began changing. America experienced a surge in inflation, and the Fed assured the public that it was ‘transitory’ i.e. going to pass quickly. I wrote in September of 2021 that unlike the Fed I thought that inflation would persist and that it was a good opportunity for the Fed and other central banks to quit their current ultra-low interest rate coupled with asset purchasing programmes policy, and it seems I’ve been proven right. Indeed, even the Fed’s chairman Jerome Powell has decided to stop using the word ‘transitory’, saying in a December 2021 interview that: “We tend to use [transitory] to mean that it won’t leave a permanent mark in the form of higher inflation, I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”
Usually, if a central bank says that inflation is transitory people believe them. Indeed, the view that inflation in America wasn’t just a temporary blip but the start of an extended period of increasing prices was quite uncommon last summer. A year or so later though, that has changed dramatically. Last week The Economist’s leader pages said that: “the Federal Reserve has made a historic mistake on inflation”, ending with: “In the 1980s the recessions brought about by Paul Volcker’s Fed laid the foundations for inflation-targeting regimes worldwide. Every month inflation runs too hot, part of that hard-won credibility ebbs away.“ I think they’re spot on about credibility, after all financial markets are built on trust, and I wonder if the image of a central bank as apolitical (ignoring the fact that monetary policy has wide ranging economic effects and is thus by its nature political) has had a hand in getting the Fed and other central banks in this pickle. As the leader notes, the Fed might well need to increase interest rates to a point where a recession is inevitable to get inflation under control, but the Fed is clearly uncomfortable with engineering a recession. If Powell and company was solely focused on keeping inflation low and stable then the choice between containing inflation and preventing a recession is a no-brainer: the Fed’s goal is to have 2% inflation, not to avoid recessions at all costs. The fact that inflation has been higher than 2% by more than a factor of 2 for almost a year now shows that the Fed has made a de facto political decision to let inflation run high to save the business cycle.
In an age where those with technical expertise and experience are often dismissed as part of the loathsome ‘establishment’ the technocrats at the Fed have by making strange choices like letting inflation run high made themselves a target for populists. If the Fed as an institution is making independent decisions as to when inflation should and shouldn’t be curtailed, which years of Washington Consensus orthodoxy shouldn’t preclude from being an option, then it needs to be more open to democratic oversight, otherwise populists will try to discredit it the way they have with other technocratic institutions. The Fed has indeed failed to keep inflation low, but as I’ve written about previously there are some potential benefits to moderate inflation. The current narrative surrounding central banks is that they should step up to the task of reining in inflation, but it’s worth asking if we as a society shouldn’t take this opportunity to ask whether the post-Volcker style of central bank is the best option any more. I say all this precisely because I suspect that the Fed and it’s rich world peers will allow inflation to run at between 5-10% in the coming decade or so as public and private debt burdens are quite high making inflating it down to clean the slate for a credit expansion driven long growth cycle like the one from the early eighties to 2008. The worst case scenario for central banks like the Fed is that they end up with the scenario I presented not by design but by being trapped in a cycle where every attempt to fight inflation triggers a market tantrum or fears of recession which forces central bankers to back down until another monthly inflation report triggers calls for central banks to do more to fight inflation and the cycle begins again. Central banks need to show that they are as technically proficient as their reputations imply by putting their foot down and getting rid of inflation or take a more political stance where they are less married to the idea of 2% inflation while simultaneously opening up to democratic oversight if they wish to continue to be well regarded. ‘Transitory’ inflation could be a minor failure which is easily recovered from or the failure which foreshadowed a coming fall from grace depending on how it’s handled.
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I've always been interested in politics, economics, and the interplay between. The blog is a place for me to explore different ideas and concepts relating to economics or politics, be that national or international. The goal for the blog is to make you think; to provide new perspectives.
Written by Karl Johansson
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Cover photo by olia danilevich from Pexels, edited by Karl Johansson
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