The inflation genie is now out of the bottle, and central bankers meeting recently in Jackson Hole, Wyo., found many culprits to blame for inflation: pandemic disrupted supply chains, slower rates of technological change, productivity challenges, demographic transition, Vladimir Putin’s invasion of Ukraine, etc. This smorgasbord of explanations is designed to deflect attention from the new and flawed framework for monetary policy created by the Fed over the last two decades, which is now falling apart.
The last time the United States experienced inflation rates of this magnitude was during the Jimmy Carter administration in the late 1970s. At that time, Fed Chairman Arthur Burns offered a mea culpa. He confessed that after a brief attempt to increase the discount rate, the Fed folded under political pressures, expanding the money supply to accommodate fiscal stimulus. By the end of that decade, prices and interest rates reached double-digit levels.
Fed Chairman Paul Volcker, with the support of President Ronald Reagan, then launched a monetarist revolution, reducing the rate of growth of the money supply and increasing the discount rate to levels required to halt inflation. Over the next two decades, referred to as the “Great Moderation,” Volcker and his successor Alan Greenspan properly restored price stability as the primary objective of monetary policy and reduced inflation to target levels. That set the stage for rapid economic growth and allowed the government to balance the budget, reducing debt as a share of gross domestic product.
Over the last two decades, however, Fed chairmen have all too often abandoned that commitment, holding interest rates well below levels consistent with stable prices. A major break occurred when the Fed introduced nonconventional monetary policies in response to the financial crisis in 2008. This included lowering the federal funds rate close to zero and engaging in large-scale asset purchases of Treasuries and other government-backed debt instruments. The Fed continued this policy over the last decade and doubled down in response to the coronavirus pandemic.
The economy has entered a new era of stagflation, not unlike that of the 1970s. In Jackson Hole, Fed Chairman Jerome Powell called for a reversal of monetary policy, properly arguing that price stabilization should now be the primary objective of monetary policy. The open market committee has significantly increased the discount rate and has committed to continue that policy until inflation is reduced to the 2 percent target level.
The Fed is now sitting on $3.3 trillion in reserve balances and $2.5 trillion in reverse repurchase agreements. Normalizing monetary policy and restoring capital market efficiency will require significantly reducing this balance sheet, and Powell has also committed to this policy.
The real challenge will be in a recession when the Fed faces the horns of a dilemma. Increasing unemployment will result in political pressure to lower interest rates even if inflation is above the 2 percent target level. The Fed will also be under political pressure to stop downsizing its portfolio and to again purchase government securities. To restore its independence, the Fed will have to repudiate nonconventional monetary policies and focus on price stability to promote more robust and sustainable economic growth.
It should NOT be required to focus on current employment levels since they are best addressed by federal, state and local fiscal, education/training and labor policies.
The bottom line is that the Fed has often folded to political pressures in the 21st century. Like Chairman Arthur Burns, Powell needs to offer a mea culpa for past nonconventional monetary policies and stick to his Jackson Hole commitments. After all, inflation essentially represents a cruel and regressive tax resulting from a combination of irresponsible and unsustainable fiscal and monetary policies.
As Milton Friedman argued, the success of monetary policy depends on prudent fiscal policy (price stabilization and debt sustainability). Our total federal debt of $31 trillion now exceeds GDP and is projected to be nearly double the level of GDP by mid-century. Debt sustainability requires Congress to close the fiscal gap and reduce debt relative to GDP. This is a difficult challenge, and Congress has not been up to the task since 2003. To restore fiscal sanity, a constitutional amendment is required to stabilize the debt at a reasonable and sustainable percentage of GDP.
We call on Congress, the states and the people to support such an amendment to help restore sustainable macroeconomic policy. We also call on Congress to revise the Fed’s mandate to focus first on price stability while also promoting long-term economic growth and eliminating the requirement to be concerned with current employment levels.