A psychologist or a novelist might be as useful as an economist in explaining what the Federal Reserve is up to these days.
The change in the Fed’s monetary policy this year has been so extreme that it’s hard to explain using economists’ tools alone. Until early this year the Fed kept short-term interest rates extremely low even as inflation heated up. Now it’s jacking up interest rates at the fastest pace in four decades to kill inflation, acknowledging that doing so will throw people out of work.
Sure, the 180-degree pivot can be justified using economic theory. Federal Reserve Chair Jerome Powell stuck to economic language on Wednesday at the news conference following the latest meeting of the Federal Open Market Committee, which had just raised the target range for the federal funds rate by another three-quarters of a percentage point (to 3 to 3.25 percent).
But there’s a personal subtext that’s hard to ignore. Powell admires Paul Volcker, the Fed chair who slew inflation in the early 1980s by raising interest rates. Raising interest rates led to a deep recession, but it eventually ushered in an era of mostly stable, non-inflationary growth. Powell would clearly rather be compared to Volcker than to Arthur Burns, a respected academic who let inflation get out of control while chairing the Fed from 1970 to 1978.
As reported in The Times, Powell was asked in congressional testimony in March if the Fed was prepared to do whatever it took to control inflation, even if that meant temporarily harming the economy, as Volcker did.
“I knew Paul Volcker,” Powell responded. “I think he was one of the great public servants of the era — the greatest economic public servant of the era.” Making clear that his own legacy was on his mind, Powell continued, “I hope that history will record that the answer to your question is yes.”
Powell’s attempt to reincarnate Volcker was clear Wednesday at the news conference, where he said: “We have got to get inflation behind us. I wish there were a painless way to do that. There isn’t.” The “dot plot” released Wednesday indicates that the Fed could raise the funds rate another 1.5 percentage points by early next year.
This tough love policy toward the U.S. economy could be correct, or it could be an enormous mistake. The economic argument in favor of raising interest rates aggressively is that the longer inflation stays high, the more likely it will become entrenched in the expectations of businesses and consumers. Acting before that happens is essential, the argument goes. Powell once expected that inflation would wane once pandemic-related bottlenecks in supply chains eased, but that hasn’t happened, and he’s not willing to wait anymore.
“Monetary policy works with a lag and the speed at which the Fed is moving is a risk, but the Fed seems willing to take it,” Ellen Zentner, chief U.S. economist of Morgan Stanley, and her team wrote in a client note on Thursday.
The “enormous mistake” camp argues that inflation is already showing signs of falling. Prices of commodities such as gasoline, copper and lumber are down sharply. The housing market has been whacked by high mortgage rates. The dollar has risen against other currencies. Stock prices are way down. All these factors put downward pressure on inflation, which will fall even more once the interest rate increases that have already been imposed begin to chill the overheated job market, this camp argues.
Critics say more tightening now has too big a downside. Senator Elizabeth Warren, a Democrat from Massachusetts, tweeted Wednesday that Powell is “already on the path” to throwing “millions of Americans out of work.”
Since both sides of the argument can be supported with economic theory and data, it’s only natural to look for other factors in decision-making. One is confirmation bias — the very human tendency to pay more attention to evidence that supports your point of view and less to evidence that disconfirms it. Another is groupthink. How else to explain that as recently as January, the Federal Open Market Committee vote to keep rates unchanged at zero to 0.25 percent was a unanimous 9-0, while this month the vote to jack up rates to 3 to 3.25 percent was a unanimous 12-0?
One figure who looms large in the debate is Lawrence Summers, who has been needling the Fed about allowing inflation to get out of control. Summers, a former Treasury secretary, was a finalist to be Fed chair in 2013, but dropped out of the running in the face of opposition from some Democratic senators. President Barack Obama instead chose Janet Yellen, Powell’s predecessor.
“It is clear that Powell has taken all of the criticism he has faced personally and refuses to go down in the history books being compared to Arthur Burns and desperately wants Larry Summers off his back,” David Rosenberg, a member of the “enormous mistake” camp, wrote to clients on Thursday. Rosenberg is founder and president of Rosenberg Research in Toronto.
I’m not saying that Powell and his other monetary policymakers are being led astray by their emotions. It could be people on the other side, such as Rosenberg, who are wrong. I just want to observe that Federal Open Market Committee members are people, too, and everything they say and do must be seen in that light.
The Readers Write
In my view, the “midlife crisis” outlined in your article on Wednesday is a crisis for rich societies that have achieved the basics in Maslow’s hierarchy of needs and are now looking for non-material fulfillment. In poor countries where finding food and shelter are the pressing needs, midlife crisis is a non-issue. I’ve seen both sides of this have- and have-not world, having been an immigrant from Guyana, an academic in Jamaica and a Canadian for half a century.
Quote of the Day
“The heralded social dividends of education are largely illusory: rising education’s main fruit is not broad-based prosperity, but credential inflation.”
— Bryan Caplan, “The Case Against Education: Why the Education System Is a Waste of Time and Money” (2018)