About the authors: Charles I. Plosser is a Visiting Scholar at the Hoover Institution and former President of the Federal Reserve Bank of Philadelphia. Mickey D. Levy is senior economist at Berenberg Capital Markets. Both are members of the Shadow Open Market Committee.
The Federal Reserve has dramatically failed in its commitment to preserve price stability. Personal consumption expenditure inflation is above 6%, the highest in 40 years, and more than three times the Fed’s 2% target. Recent data shows no signs of slowing down.
The Fed now faces a daunting task. While the Federal Open Market Committee has recently accelerated its pace of raising interest rates, it must be resolute in its aggressive action to reduce inflation. By delaying its response to the sharp rise in inflation, the Fed undermined its own credibility. The Fed can only restore its reputation by pairing its tough new language with other important actions that will ensure success.
The sharp decline in the stock market and other economic statistics suggest that the Fed’s belated attempts to control inflation are likely to generate a recession. These short-term economic costs may now be unavoidable, but they are necessary if the Fed is to restore credibility and a low inflation environment conducive to sustained and healthy economic performance.
The Fed needs to recognize the factors underlying the policy mistakes that have contributed to this situation and adjust its policy framework accordingly. Otherwise, these mistakes will likely be repeated.
The Fed’s delayed responses to rising inflation stem from several factors. He attributed the acceleration in inflation to transient supply factors rather than a surge in demand induced by excessive monetary and fiscal policies. The Fed ignored its data-driven mantra, choosing not to react to accelerating inflation and tightening labor market data. He relied too heavily on his verbal assertions that inflation was transitory to control inflationary expectations, rather than on policy measures.
These policy mistakes stemmed from the strategic plan the Fed rolled out in August 2020. The strategy was largely driven by fears of a downward spiral in inflation expectations as interest rates approach zero. He neglected the risks of rising inflation.
The strategy adopted a new asymmetric interpretation of the Fed’s dual mandate that signaled a strong inflationary bias and granted excessive discretion to the Fed in interpreting the mandate. It prioritized the employment target over maximum inclusive employment and adopted a flexible form of average inflation targeting that explicitly favored higher inflation.
Strangely, the Fed explicitly announced that it would no longer react to expected inflation but would only react to actual inflation, and only after the economy had reached its revised full employment target.
The surge in inflation was predictable given the excessive fiscal and monetary policy responses to the pandemic, but nevertheless caught the Fed off guard. Deficit spending of 27% of gross domestic product was well above the 9% drop in real GDP. The Fed chose to finance a substantial part of this additional spending by buying more than half of the newly issued Treasury debt. This generated a surge in aggregate demand while pandemic-related supply shortages worsened inflation.
The Fed’s assumption that inflation would remain low, as it did after the financial crisis, contributed to its misinterpretation that inflation was temporary. The Fed’s expectation of “substantial progress” toward its high but indefinite maximum inclusive jobs mandate has delayed the unwinding of its asset purchases, including purchases of mortgage-backed securities in a depressed housing market. booming. Growing evidence of generalized inflation and excessively tight labor markets has been ignored.
The Fed is now under pressure to act aggressively to make up for its own policy mistakes. This approach is reminiscent of old “go-stop” policies where the Fed aggressively pursued its employment targets only to find itself forced to reverse course and aggressively tighten policy to control high inflation.
We are now paying the price for excess stimulus. More timely monetary responses would have allowed the Fed to retain more of its reputational capital, and the current problem would likely be less severe.
The Fed should eventually raise rates above the underlying inflation rate. In doing so, the Fed must be prepared to tolerate economic weakness and rising unemployment that may arise. The Fed’s resolve must not waver under political pressure. The current situation explains why independence is such an important feature of a healthy central bank. Monetary policy may require choices that may be politically undesirable in the short term, but which are desirable to ensure a better outcome for the economy in the long term.
The Fed’s new strategic plan has largely contributed to the series of errors and must be revised. A more balanced interpretation of its employment and inflation mandate needs to be restored. A more transparent react function should be articulated to allow the public to better understand what data addiction really means. Such adjustments would lead the Fed to adopt more rules-based guidelines for the conduct of monetary policy and result in fewer errors of judgment and better economic performance.
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