About the authors: Charles I. Plosser is a visiting fellow 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 failed to deliver on its commitment to preserve price stability. Inflation for personal-consumption expenditures is over 6%, the highest in 40 years, and more than three times the Fed’s target of 2%. Recent data show no sign of deceleration.
The Fed now faces a daunting task. While the Federal Open Market Committee has recently stepped up its pace of interest-rate increases, it must be resolute in its aggressive action to reduce inflation. By delaying its response to the sharp rise in inflation, the Fed has generald its own credibility. The Fed can only restore its reputation by matching its new tough language with further significant actions that will ensure success.
The sharp decline in the stock market and other economic statistics suggest the Fed’s belated attempts to tame inflation will likely generate a recession. These short-run economic costs may now be unavoidable, but are necessary if the Fed is to re-establish its credibility and a low-inflation environment that is conducive to sustained, healthy economic performance.
The Fed must acknowledge the factors underlying the policy mistakes that contributed to this situation and adjust its policy framework accordingly. Otherwise, such errors will likely be repeated.
The Fed’s delayed responses to the rise in inflation stemmed from several factors. It attributed the acceleration of inflation to transitory supply factors rather than a surge in demand driven by excessive monetary and fiscal policies. The Fed ignored its mantra of being data dependent, choosing to not respond to the accelerating inflation and tightening labor market data. It relied too much on its verbal assertions that inflation was transitory to control inflationary expectations, rather than policy actions.
These policy errors stemmed from the strategic plan the Fed rolled out in August 2020. The strategy was driven largely by concerns of downwardly spiraling inflationary expectations when interest rates are near zero. It neglected the risks of rising inflation.
The strategy adopted a new, asymmetric interpretation of the Fed’s dual mandate that signaled a strong inflation bias and granted excessive discretion to the Fed in interpreting the mandate. It prioritized the employment objective to 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 anticipated inflation but would only respond to actual inflation, and only after the economy had achieved its revised full-employment objective.
The spike in inflation was predictable given the excessive fiscal and monetary policy responses to the pandemic, but nonetheless caught the Fed flat-footed. Deficit spending of 27% of gross domestic product was magnitudes larger than the 9% decline in real GDP. The Fed chose to finance a substantial portion of this additional spending by purchasing over half of the newly issued Treasury debt. This generated a surge in aggregate demand while pandemic-related supply shortages aggravated inflation.
The Fed’s presumption that inflation would remain low, as it did following the financial crisis, contributed to its misread that inflation was temporary. The Fed’s waiting for “substantial progress” toward its lofty yet undefined maximum inclusive employment mandate delayed unwinding its asset purchases, including purchases of mortgage-backed securities amid a booming housing market. Increasing evidence of pervasive inflation and excessively tight labor markets was ignored.
The Fed is now under pressure to act aggressively to compensate for its own policy errors. This approach is reminiscent of the old “go-stop” policies where the Fed aggressively pursued its employment goals only to find itself having to reverse course and aggressively tighten policy to control high inflation.
We are now paying the price for the 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 must eventually raise rates above the underlying rate of inflation. In doing so, the Fed must be willing to tolerate economic weakness and the higher unemployment that may arise. The Fed’s resolve must not weaken under political pressure. The current situation explains why independence is such an important feature of sound central banking. Monetary policy can require choices that may be politically undesirable in the short run, but are desirable to secure a better outcome for the economy in the longer run.
The Fed’s new strategic plan contributed significantly to the string of mistakes and must be revised. A more balanced interpretation of its employment and inflation mandate must be re-established. A more transparent reaction function should be articulated that allows the public to better understand what data dependency actually means. Such adjustments would lead the Fed more rules-based guidelines for monetary policy and will result in fewer judgment errors and economic performance.
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