In a thought-provoking article published by the IMF in April, Ruchir Agarwal and Miles Kimball argue for moving away from a “paper money standard” and toward an “electronic money standard.” The promised benefits include shorter recessions and lower average inflation. These benefits are said to result from eliminating the “zero lower bound” to nominal interest rates, giving the Federal Reserve the power to cut nominal interest rates as far as it needs—even into negative territory—to spur recovery from a recession. Even if nominal interest rates are only 2 percent going into the recession, the Fed could cut rates by 5 percentage points (say), reaching ‑3 percent, if that’s what they think a prompt recovery requires. The ability to conduct a negative interest rate policy, Agarwal and Kimball (hereafter AK) argue, removes the need to have an inflation target well above zero in order to keep nominal interest rates high enough to allow 5 percentage points of rate-cutting.[1] It thereby encourages the Fed to lower its inflation target from 2 percent to zero.

The “zero lower bound” is created by the unlimited availability of a zero nominal return on currency: nobody will accept significantly negative returns when they can always get a zero return (or more precisely, zero minus a small cost of storage) by holding Federal Reserve Notes. Think of the scene in Breaking Bad where Walter and Skyler White survey a room-sized storage locker where they are keeping millions of dollars in stacks of $100 bills. A back-of-the-envelope estimate indicates that their storage costs were less than one-tenth of one percent per year. Under such conditions, the public will not accept bond returns more than one-tenth of one percent per year below zero.

The “electronic money standard” the authors advocate is a novel kind of fiat dollar standard in which Federal Reserve Notes (the circulating paper part of the Fed’s monetary liabilities) would no longer always provide a zero return because they would no longer always trade 1:1 against bank reserves (the account-balance electronic part). AK note that it isn’t necessary to eliminate large denominations of paper currency (as some other proposals to enable a negative interest rate would, for example Kenneth Rogoff’s) to stop it from being a zero-nominal-return asset that sets a zero lower bound on nominal interest rates. It is only necessary to ensure that holding currency also pays a negative rate when the Fed pays a negative interest rate on bank reserves. When a negative interest rate on bank reserves is deemed necessary to fight recession, AK propose devaluing paper dollars against electronic dollars at a corresponding rate. If (for example) bank reserves pay ‑3% per annum, paper dollars are to lose their value at 3% per year against electronic dollars held on the books of the Fed (bank reserves) and on the books of the banking system (deposit balances).

AK do not spell out a specific mechanism in their 2022 paper for imposing a negative return on cash, but refer to a 2019 paper in which they consider several mechanisms. There they rate as the “first-best” policy one that “takes paper currency off par.” In essence, the Fed would announce and maintain a sliding peg between Federal Reserve Notes and bank reserves. When the policy rate is ‑3 percent per year, what is a “$100 bill” at the start of the year will be convertible into (and purchasable with) only $97 of electronic dollars at year’s end. Conversions on intermediate dates will fetch intermediate rates, so that “the paper currency smoothly depreciate[es] … over the course of the year.” There is no limit on the Fed’s ability to enforce its chosen exchange rate because it can issue or buy back Federal Reserve Notes in unlimited quantities. Private-sector businesses and individuals will discount paper currency at the rate their banks discount it for deposits, and their banks will discount it at the rate the Fed discounts it in exchange for bank reserves.

The AK proposal usefully shows that eliminating the zero lower bound can be separated from eliminating large-denomination paper currency and the financial privacy it provides. It also usefully makes the point that a positive secular inflation rate is not necessary to make room for anti-recession policy.

Assuming that we retain a fiat dollar, would enacting the AK proposal make the public better off? That is, would the typical dollar-holder benefit from enabling the Fed to impose negative returns on dollars in all forms? The answer isn’t obviously no. Note that a 2 percent average dollar inflation rate (the Fed’s currently declared target) already imposes a ‑2 percent average real return on dollar currency holders. If (as AK hope it would) enabling negative interest rate policy in this way really would lead the Fed to lower its non-recession inflation target to zero percent from 2 percent, and a negative nominal rate on currency would be imposed less than half the time, the program might actually raise the average expected real return on holding U.S. currency.

Such a program would be dominated, however, by a program of lowering the inflation target to zero and combatting recessions in an equally effective alternative way that does not require negative nominal rates, if such an alternative way were available. (A plausible alternative will be discussed momentarily.) Judged by that benchmark, the devaluation of paper currency is a welfare-reducing tax on currency, compared to currency that holds its value in the unit of account. I have written before about the dubious wisdom of punishing money-holders in order to escape the zero lower bound.

AK’s proposal thus promises to improve money-holders’ welfare only if (1) it actually results in a lower combination of (inflation + negative nominal own-return on money) on average, or, failing that, (2) negative interest rate policy is so much more effective at recession-fighting than the alternative that its benefits exceed its burden on money-holders. The second has not been shown, and may be considered doubtful. Note that the U.S. economy has just recovered rapidly from a sharp recession without cutting interest rates below zero, and without cutting them more than 1.5 percentage points. The Fed’s policy instrument of interest on reserve balances was 1.6 percent on 1 February 2020, the eve of the pandemic recession of 2020, fell to 0.1 percentage points over the next six weeks, and remained there for the next 15 months. Real output plunged for the first two quarters of 2020, then recovered its losses in the level of real GDP over the next four quarters, and even closed the gap to 99.5 percent of the full-employment or “real potential GDP” growth path over the following two quarters (see Figure 1).

Figure 1: Real GDP and Real Potential GDP, 2014–2022.

Granted, this was an atypical recession and recovery. The point I seek to make in citing it is only that prompt recovery is at least sometimes possible without a deep cut in the Fed’s interest-rate instrument. The broader point I want to make is that, under alternative policy procedures, counter-cyclical monetary policy does not require the Fed to use an interest rate instrument at all. The class of Taylor Rules, which specify the proper value of an interest rate target or instrument as a function of current macro data, does not exhaust the set of viable monetary policy rules with recovery-supporting feedback from current macro data.

The macro economist Bennett McCallum (2000) long ago formulated a feedback rule for using the monetary base—the degree of quantitative easing—as an instrument to target the path of nominal income. Under the McCallum Rule procedure, the Fed varies the rate of growth of the monetary base in response to the moving-average rates of growth of base velocity and real income, without feedback from interest rates. Until 2015 the monthly St. Louis Fed publication Monetary Trends tracked whether monetary base growth was currently above or below a range of McCallum Rule prescriptions, just as it also tracked whether the Fed Funds rate was above or below a range of Taylor Rule prescriptions. Unlike a Taylor Rule, a McCallum Rule does not require using an interest rate target or instrument.[2] It does not require an estimate of the real natural rate of interest[3], which is a well-known problem in implementing a Taylor Rule. It is agnostic about the role of interest rate changes in monetary policy transmission.

The intuition behind the effectiveness of using the monetary base as the policy instrument is straightforward, although unfortunately less familiar today than the logic of IS-LM and the Taylor Rule. It begins with considering it an appropriate goal for fiat monetary policy to avoid creating or prolonging a monetary disequilibrium, meaning an excess supply or demand for money balances by the public at the current price level. (This theme was central to the work of Leland B. Yeager and the late Axel Leijonhufvud, who emphasized that recessions characterized by an aggregate excess supply of non-money goods are logically equivalently characterized by an excess demand for money balances.) To minimize monetary disequilibrium, the system should expand the supply of fiat money in response to signs of an unsatisfied excess demand for money balances, and contract it in response to signs of excess supply.

In a closed economy, the central bank manages the supply of base money. Quantitative easing or tightening—open market purchases that enlarge the monetary base, or sales that shrink it—expands or contracts broader money in the hands of the public, supposing that the “money multiplier” remains the same (under the Federal Reserve’s current operating system, this requires that the interest rate on reserves that the Fed pays banks reserves tracks the risk-free rate that banks could earn on Treasuries). In 2020 the Fed quite properly acted to expand M2 in response to the spike in the demand to hold M2 balances, or in other words, in response to the plunge in M2 velocity. The expansion did not come soon enough to prevent nominal GDP from falling in 2020, but it was more than enough to restore nominal GDP to its pre-pandemic path by the end of 2021 and to push it well above that path in 2022 (see figure 2).

Figure 2: Nominal GDP and Nominal Potential GDP.

The McCallum Rule (McCallum 2000, p. 52), for readers who are unfamiliar with it, specifies the appropriate quarterly growth rate for the monetary base as

where (all variables in logs) Δb_t is the quarter-over-quarter change in the adjusted monetary base, Δν_t^a is the moving-average change in base velocity over the previous 16 quarters, Δx_t* is the target level of nominal GDP, Δx_t–1 is lagged actual nominal GDP, and the parameter λ= 0.5. The rule (the first equation) prescribes that base money growth should offset base velocity growth shocks. And, if nominal GDP is undershooting its reference path, the Fed should loosen monetary policy by increasing the expansion of base money by half the discrepancy. The second equation says that the nominal income target Δx_t* is the sum of the desired price level π* plus the 40-quarter moving average of real GDP Δyt*. In sum, the rule stabilizes nominal GDP along a pre-determined path using a monetary instrument. McCallum calibrated the λ parameter and the moving-average lengths using various simulations, and found that the calibrated rule’s counterfactual performance across a variety of macro models was better than the Federal Reserve’s actual performance even during the Great Moderation.

AK take for granted that anti-recession monetary policy must work by cutting an interest rate target or instrument. They observe that “[b]efore zero lower bounds became a problem,” postwar central banks “typically cut nominal rates by 5 to 6 percentage points to restore the economy to its full potential.” But such a method of operation is not dictated by the structure of a monetary economy on a fiat standard. It derives from a self-imposed policy framework. In the pre-2008 monetary regime, the Fed used the Federal Funds rate as an intermediate target, which may be interpreted as a guideline for supplying the quantity of money sufficient to meet the quantity of money demand at the desired price level. Switch from using an interest-rate-targeting procedure to using a monetary aggregate instrument, and it stands to reason that the “need” for cutting nominal rates by 5 or 6 percentage points to alleviate an excess demand for money disappears with it. To put the point another way, zero lower bounds are “serious obstacles to monetary policy,” as AK put it, only insofar as monetary policy is conducted using an interest rate as its instrument or intermediate target. Where AK comment that the zero lower bound “is not a law of nature, but a policy choice,” I suggest that the same is true about the need to fight an excess demand for money by cutting an interest rate instrument or target.

McCallum (1989) provided some evidence that a Taylor Rule (during a period in which the zero lower bound is not binding) is no more effective at mitigating recession than a McCallum Rule. If this finding is persuasive empirically (an update would be welcome) or theoretically, then it is hard to justify imposing the burden of negative interest rates on depositors and the burden of currency devaluation on currency-holders. For this reason, devaluing currency would rightly be highly controversial among members of the public—nearly as much as abolishing currency altogether.

References

McCallum, Bennett T. (1989). “Targets, Indicators, and Instruments of Monetary Policy,” NBER Working Paper 3047 (July).

McCallum, Bennett T. (2000). “Alternative Monetary Policy Rules: A Comparison with Historical Settings for the United States, the United Kingdom, and Japan,” Federal Reserve Bank of Richmond Economic Quarterly 86 (Winter), pp. 49–79.

***

[1] George Selgin cogently criticizes a proposal to raise the Fed’s inflation target, and thereby nominal interest rates, in order to give the Fed more room above zero to cut nominal rates in a recession.

[2] An “instrument” here, following standard monetary policy usage, is a variable that the Fed can directly control in the execution of monetary policy. Today the interest rate on reserves is an instrument. Under the pre-2008 Fed procedures, the Fed Funds rate was not an instrument but an intermediate target. It was a market rate that the Fed tried to keep in a target range as a guideline for keeping bank reserves at the desired degree of scarcity. The monetary base was an instrument then and remains an instrument now.

[3] I owe this point to Patrick Horan.

[Cross-posted from Alt‑M.org]

I still have a 1979 bookmark that says, “INFLATION IS A PAIN IN THE GAS.”

Funny but wrong. U.S. gasoline prices follow gyrations in world oil markets, which depend on global (not domestic) supply and demand.

What actually happened in 1978–80, an important German study from Bruegel reminds us, was the Iranian revolution and the Iran-Iraq War: “The 1978 Iranian revolution decreased global supply by 4 percent and led to a price increase of 57 percent. The 1980 Iran-Iraq war decreased global supply by 4 percent and led to a price increase of 45 percent.”

What happened to world oil markets in 2020 was a global pandemic, with falling oil and gas prices followed by a sizable loss of oil and gas production capacity in the U.S. and elsewhere. What happened in 2021 was mostly the phasing-out of governmental lockdown schemes which allowed production, commerce, and transportation to bounce back faster than oil and gas production could. China, however, has lately reverted to primitive lockdown schemes, which might lower world demand for oil and everything else by shrinking the Chinese economy. 

What happened to crude oil and gasoline prices in 2022 was the Russian invasion of Ukraine, though partisans falsely deny the link between war and oil markets and instead blame President Biden for U.S. gasoline prices – which, as in 1979, are considered synonymous with “inflation.”

Recently, the oil futures market has been rattled by proposed EU sanctions intended to shrink the world supply of Russian oil.

The U.S. retail price of gasoline reached a record high of $4.37 a gallon yesterday, while global news pushed the price of WTI crude oil future down by 6.1%. The next day, “Crude oil futures were sharply lower in mid-morning Asian trade May 10, extending steep overnight declines,” due to “hurdles to an European Union-ban on Russian oil and the ongoing spread of COVID-19 in China.” The Financial Times noted, “Brussels has shelved its plans to ban the EU shipping industry from carrying Russian crude as it struggles to push through its latest sanctions package because of anxiety among some member states about the economic impact of the measures.”

The Bruegel study notes, “Such a measure would not prevent Russia from exporting altogether – it would find alternative buyers, such as China, India or others, as it already does – but an embargo would certainly increase the discount on Russian oil… If, on net, Russian exports decreased, the world price would go up, unless the drop in Russian exports was offset by the decisions of other producers, from Saudi Arabia to Iran to Venezuela, to increase production.”

Regardless of the net effect of a hypothetical EU ban on Russian oil, the fact that it suddenly appeared far less likely to happen was followed by lower world oil prices and higher prices for U.S. bonds and stocks. If the world (and U.S.) price of crude oil remains lower for a while, then U.S. gasoline prices will also turn down later.

Each country imagines inflation to be a national problem to be entirely blamed on national fiscal authorities or on each nation’s central bank. Yet March CPI inflation averaged 8.8% for all 38 countries in the OECD, and 7.8% for the 27 EU countries.

Economists at the Federal Reserve Bank of San Francisco, in the FRBSF Economic Letter, ask a narrower question: “Why is U.S. Inflation Higher Than in Other Countries?” 

They first begin by acknowledging that there have been some uniquely huge global events driving world prices down in 2020 (COVID-19 lockdowns causing long-term loss of productive capacity) and other powerful forces driving global prices up since reopening in the Spring of 2021 – most recently the Russian invasion of Ukraine.

From April 2020 to February 2021 most states and nations imposed strict COVID-19 restrictions shutting down substantial capacity in production and distribution that could not easily be reversed, leaving a legacy of supply bottlenecks in everything from oil and semiconductors to toilet paper, pork bellies, and truck drivers.

After state and national economies reopened in the Spring of 2021, many prices snapped back from the pandemic-deflated base, contributing to big year-to-year percentage changes in monthly consumer and producer price indexes. Texas crude oil, for example, jumped from $16.55 a barrel in April 2020 to $61.70 in April 2021.

This year, the price of WTI crude oil began rising quickly from $80 in early January as Russia began amassing troops around and Ukraine to about $90 before the February 24 invasion and $108 in March. Prices of grains, metals, and natural gas also rose sharply as world supplies from Russia and Ukraine were slashed by the war itself and by U.S. and EU sanctions to thwart Russian sales. The U.N. World Food Price Index rose 1.4% in January 2022, 4.3% in February, and 6.3% in March.

Because such supply shocks increase global inflation numbers, the FRBSF economists begin their study by properly acknowledging that “Problems with global supply chains and changes in spending patterns due to the COVID-19 pandemic have pushed up inflation worldwide.”

However, they continue, “since the first half of 2021, U.S. inflation has increasingly outpaced inflation in other developed countries [defined by Canada and 8 European countries]. Estimates suggest that fiscal support measures designed to counteract the severity of the pandemic’s economic effect may have contributed to this divergence by raising inflation about 3 percentage points by the end of 2021.”

The most noteworthy finding of the FRBSF study is that last year’s relatively higher U.S. inflation was the result of last year’s fiscal policy –not monetary policy. Yet the U.S. Federal Reserve is being asked to somehow undo the hangover from last year’s fiscal excess by this year’s monetary squeeze. It would be hard to argue that U.S. inflation was higher last year because of an easier monetary policy than Europe since the Euro fell from $1.22 in January 2021 to $1.08 this April. Recent experience is the opposite of what happened as a result of the U.S. dollar devaluations of 1971–79.

If the FRBSF study is correct that the cause of two or three percentage points of relatively higher U.S. inflation last year was COVID-19 relief spending, then the relatively good news (for the U.S.) is that those “pandemic response programs” ended last year and no longer subsidize consumer spending.

As Wall Street Journal columnist Greg Ip concluded, “U.S.-specific factors such as President Biden’s stimulus last year may explain only 1 to 2 percentage points of the rise in inflation. For the rest, we need to look to global factors” [emphasis added].

The U.S. and the world still have the ugly global price pressures of war and supply-chain disruptions to deal with. There is nothing that escalating Federal Reserve interest rates on bank reserves can do about war-related losses of energy and food, except to push the dollar up and thus make oil and grain imports more expensive in Euro, pounds, and yen than in dollars.

Instructive as it is, the FRBSF effort to explain 1 or 2 percentage point divergences from global average inflation demonstrates that such differences were minor compared with powerful global forces pushing all national inflation rates higher.

Exploring differences among national inflation rates was an interesting question last year. But the bigger question is not why national inflation rates among advanced countries differed by a few percentage points last year but why inflation movements among advanced economics are so remarkably similar over decades ­– sharing movements up, down, or sideways that look as synchronized as the legs of the Radio City Rockettes.

The graph compares year-to-year percentage changes in consumer prices in the Euro area, the U.S., Canada, and the U.K.

A large part of the explanation for national inflation rates moving up and down in similar waves is that consumer price indexes are greatly affected by big oil price spikes – such as 2008 and 2022 in this graph, but also 1973, 1980, 1990, and 2000. That is why many economists argue that if central banks try to fine-tune national inflation statistics they should focus on “core” inflation data which ostensibly excludes food and energy. Yet the core U.S. PCE price index slowed to a 3.5% annual rate in February and March before the Fed announced a series of interest rate hikes. And even core inflation rates are greatly affected by global prices of oil and natural gas which, in turn, affect farm and food costs.

“The bloody conflict in Ukraine is already driving food and energy prices higher,” notes former Fed Vice-Chairman Alan Blinder, “which will boost headline inflation in the coming months. Core inflation won’t be immune because food and energy prices seep into virtually all other prices, albeit in muted form. What product doesn’t include energy in its cost, either directly (to keep the lights on) or indirectly (via delivery trucks)?”

I wrote “Inflation is Largely a Global Problem” four years ago, but that point has become crucial today. The most obvious “global factor” shared among otherwise different countries is prices (in dollars) of internationally traded commodities, such as grains, crude oil, and natural gas.

Because household budgets are limited, a sustained increase in the cost of some important things (gasoline and meat) must eventually reduce the demand for and price of other things. A recent CNBC survey thus shows households with fairly high incomes cutting back sharply on spending. In the short run, however, the global surge in food and energy prices pushes every country’s headline inflation numbers higher.

Looking only at “core” inflation rates –as the San Francisco Fed study does– evades this year’s soaring food and energy prices that are getting by far the most attention from angry consumers, the media, politicians, and central bankers.

Soaring food and energy prices have been repeatedly emphasized by journalists and economists as the reason for urging the Fed and ECB to raise interest rates repeatedly to “end inflation” (in food and energy prices) and “lower the price at the pump.” But how are higher domestic interest rates and a soaring dollar supposed to lower global fuel and food prices, if not by generating a global recession?

Even global recessions have only ephemeral cyclical effects, with no predictable influence on longer-run inflation trends. Once recessions are underway, previous increases in central bank interest rates are always and everywhere followed by rapid reductions in central bank interest rates. We have often travelled this road before. Do we really need to take the same trip again?

Federal Reserve officials spent months talking-up their visions of a linear upward path for the overnight federal funds rate on bank reserves, but with few clues about when the increase might stop or why.

But markets do not wait for the Fed to act. The policy-making Federal Open Market Committee (FOMC) had done nothing until now except to raise the fed funds rate a quarter point in March. Yet they nonetheless managed to double mortgage interest rates and crash the value of bonds and stocks in retirement accounts by simply talking increasingly boldly about what FOMC members “project” might happen to the fed funds rate in the future.

There was little to learn from today’s unsurprising half-point increase in the fed funds rate and a year-late start at undoing the QE bond-buying spree. That and much more was already fully capitalized in the huge fall in bond prices and rise in their yields.

What matters is not what happened today but what happens next. Future interest rates and prices are deeply dependent on global markets. Future interest rates will not necessarily do what Fed officials predict or want but will instead change with this unruly world.

Global bond traders were typically quick to liquidate long-term investments as FOMC projections and statements pointed to faster and longer increases in short-term rate. Yet investors have strong incentives to look at much more information than just Federal Reserve officials’ diverse and variable statements. That may explain why the yield on 2‑year Treasury bonds is a much quicker and more accurate predictor of the fed funds rate than the periodic “projections” of the Federal Open Market Committee.

A rising fed funds rate is always followed by falling fed funds rate, eventually. When the fed funds rate is reduced before a recession begins, we call that a “soft landing.”

A rare soft landing occurred in 2018–19, but it was not the result of brilliant planning by the FOMC. What the Fed planned to do was to keep raising the fed funds rate to 3–4%. But investors in 2‑year bonds bet that would not be sustainable. As the 2‑year yield began to fall below the fed funds rate the yield curve inverted and the Fed reacted by following the market back down.

The graph shows the FOMC’s longer-run projections before and after the soft landing. “The longer-run projections are the … federal funds rate to which a policymaker expects the economy to converge over time in the absence of further shocks and under appropriate monetary policy. They represent “the value of the midpoint of the projected appropriate target range for the federal funds rate or the projected appropriate target level for the federal funds rate at the end of the specified calendar year or over the longer run… For each period, the median is [usually] the middle projection.” The three highest funds rate targets represent the high end of the range shown as a green dotted line; high targets are shown in orange. Note that the median FOMC targets never anticipated a fed fund rate lower than 2.5% (median) or 3% (high). Some still speak of a 2.5% fed funds rate as a mystical “neutral” goal.

The yield on 2‑year Treasuries (the red line) clearly anticipated each uptick in the federal funds rate (in black), and jumped far ahead of the Fed by November 8, 2018, when the 2‑year yield of 2.98% was well above the 2.25% ceiling on fed funds. Despite slipping bond yields, the Fed nonetheless raised the top of its fed funds rate to 2.5% on December 21 and kept it there through July 30, 2019. But by then 2‑year yield had dropped to 1.85% leaving the yield curve sharply inverted with overnight interest rates on bank reserves sharply higher than the return on 2‑year Treasuries.

In early 2019, the FOMC central planners did not change their mind about a minimum (or “neutral”) fed funds rate of 2.5%. But the world market for short-term bonds knew the economy could not sustain that high a fund rate, so the yield curve inverted. Since banks borrow short and lend long, the Fed had to either back-off of its green line ambitions for the funds rate or watch an increasingly inverted yield curve collapse lending and the economy. The Fed backed off, so the landing was soft – until the COVID pandemic and lockdown collapsed world production and commerce in ways that still severely constrain supply capacity.

What (aside from an unexpectedly bad global recession) might, as in 2019, cause the Fed to rethink its current schedule of repeated 50–75 basis point interest rates increases for some undefined period?

An end to war in Ukraine and related commodity supply losses would help. So would and end to crippling export lockdowns in China. However, since the Fed claims to be targeting core PCE inflation, simply a sustained continuation of the slowdown in core U.S. consumer inflation we saw this February and March really ought to suffice.

Core inflation slowed substantially in February and March to less than 0.3% a month (.029%). The core personal consumption expenditures (PCE) price index rose more slowly this March than it did a year ago (as shown by the blue bars in the graph).

The backward-looking year-to-year price change nonetheless still appeared misleadingly high this March (5.2%) because of rapid price increases last year ­– during the second and fourth quarters.

The red line in the graph projects that if the February to March monthly pace continues for the next three months, the year-to-year increase in core PCE inflation would slow from 5.2% in March to 4.5% in April, 4.2% in May and 4% in June.

If monthly gains of 0.29% continued for twelve months, core inflation would average 3.5%. Monthly changes could turn either lower or higher, of course, but recent experience is compelling evidence of moderation rather than acceleration.

The Fed has always stressed that it focuses primarily on “core” inflation (which excludes some but not all food and energy prices). That distinction is particularly essential right now because Russian war and sanctions have clearly boosted world oil and grain prices.

In a March 16 press conference Federal Reserve Chairman Jay Powell said, “Really what we’re looking for … is month‐​by‐​month inflation coming down.”

On May 3–4, when the Federal Open Market Committee (FOMC) meets to contemplate a series of sizable increases in the federal funds rate, one hopes they will take notice of the fact that month-by-month core inflation has been coming down.

A Wall Street Journal editorial, “Rumors of Stagflation,” describes accelerating inflation in the first quarter GDP report: “The GDP decline … coincided with an accelerating rise in prices. The GDP price index rose at an 8% annual rate on top of 7.1% in the previous quarter. The Fed’s preferred inflation measure, personal consumption expenditures, rose 7%, when its target is 2%.”

The Fed’s preferred inflation measure is really the “core” personal consumption index which excludes some but not all food and energy prices. The Core PCE was up 5.2% in the first quarter, nearly the same as 5% in the fourth quarter of last year and below 6.1% in the second quarter. There is no “accelerating inflation” in the measure the Fed claims to be watching.

The PCE index measures prices consumers pay, including prices for imports. The GDP index excludes prices of imports because they are not part of our domestic product. Most importantly, the GDP index includes export prices for U.S. goods and services (paid by foreign firms, consumers, and governments, not Americans).

Russia’s war with Ukraine has been an unquestionably massive new shock to the global supply and prices of oil and gas, grains, and oilseeds. Talk of “substantial” increases in the fed funds rate with “much higher rates… coming” has pushed the dollar up 8.3% against the Euro, 8.6% against the pound and 13.7% against the yen. This makes the war spike in commodity prices much tougher on other countries, with The Economist’s April 19 commodity index 22% higher than a year ago in Euro compared with 9.4% in dollars.

It would be reckless for the U.S. or European central bank to base monetary policy on any non-core price index that does not even attempt to exclude energy and food prices, such as the U.S. GDP index. But that is only part of the problem. The GDP index greatly magnifies the price distortion from the Russian war because it includes the soaring volume and prices of U.S. exports of liquified natural gas (LNF), coal, grains, and soybeans. The volume of LNG exports is up 25% this year, for example, and the price has exploded. This further increases the GDP price index, as do exports of U.S. scarce grain, metals and more.

Without the shock of war and sanctions to export prices and the headline PCE, the annualized rise in the GDP deflator would probably have been 5% or less.

Central banks are not going to find the right policies by headlining wrong inflation numbers.

The distinguished contributors to Populism and the Future of the Fed examine populist demands to expand the Fed’s mandate and the threat to the demarcation between fiscal and monetary policy. All the essays, except those by Charles Plosser and me, stem from Cato’s 39th Annual Monetary Conference, which took place virtually on November 18, 2021.

The 2008 financial crisis and the COVID-19 pandemic have greatly expanded the Fed’s scope and power. As the bright line between monetary and fiscal policy fades, and the threat of fiscal dominance increases, a robust discussion of the Fed’s future is warranted.

This volume features highly readable essays that provide a broad perspective on core issues—including the populist challenge to Fed independence, fiscal dominance and the return of inflation, the limits of Fed power versus the expansion of its dual mandate, the strange world of helicopter money, and fiscal QE (i.e., using the Fed’s balance sheet to support off-budget spending).

One could argue that those who want the Fed to allocate credit, help fund a Green New Deal, engage in helicopter drops, and so on, are well intentioned. However, the real issue is whether such actions are consistent with long-run price stability and the rule of law.

Thus, several questions come to mind: (1) What are the limits to what the Fed can do and what it should do in a free society? (2) Where do we draw the line between fiscal and monetary policy? (3) Do we want an activist central bank with wide discretion or a limited central bank guided by a monetary rule? (4) What are the risks populism poses for the conduct of monetary policy, Fed independence, and central bank credibility? (5) Can the Fed control inflation if populism and fiscal QE become pervasive?

The trademark of this book, as Jeb Hensarling, former chairman of the House Financial Services Committee, noted, is that it “brings together some of the greatest thought leaders and monetary policy scholars to examine exactly how the Fed is being politicized and what that means for our economy.”

In the lead chapter, Raghuram Rajan, a professor of finance at the University of Chicago’s Booth School, observes:

Populism implies distrust in elite institutions, their objectives, and their operational decisions.… Central banks are the most elite of institutions, staffed by pointy-headed economists from elite institutions, speaking in an argot that only a chosen few understand.

The authors in this volume avoid jargon and seek to address fundamental issues surrounding monetary policy in a clear and compelling manner that will help improve both policymakers’ and the public’s understanding of the complex relationship between politics, policy, and the rule of law. Moreover, they provide different perspectives—legal, philosophical, historical, theoretical, and ethical—in reflecting on the role of the central bank in a democracy.

John B. Taylor, a professor of economics at Stanford University, described the book by saying:

These beautifully written, jargon-free essays provide a much-needed and careful assessment of the Fed’s future following the 2008 financial crisis and COVID-19. Both events created populist demands for a host of new discretionary actions. The challenge is to restore a Fed with more limited power that follows well-understood rules and procedures.

Now, more than ever, it is important to understand the implications and consequences of populist policy if the country is to achieve monetary stability and long-run prosperity. As Sir Paul Tucker, author of Unelected Power: The Quest for Legitimacy in Central Banking and the Regulatory State, noted in recommending Populism and the Future of the Fed:

Populism, whether left or right, is short-termist. Central banking is about the long-term economic and political benefits of monetary system stability. Read this book to help make sense of the Fed’s wobbles.

The recent—and largely unexpected rise in inflation—has shown beyond a doubt that central bankers are not omnipotent. It may be true that, “Like Ulysses at the mast, political authorities can resist the inflationary sirens under a delegated depoliticized monetary policy,” as Charles Goodhart, a former member of the Bank of England’s Monetary Policy Committee, and Rose María Lastra, the Sir John Lubbock Chair in Banking Law at the Centre for Commercial Law Studies, Queen Mary University of London, point out in their chapter. However, a nagging question remains—namely, “How does one reconcile this model with the new political realities?” This volume will help shed light on that fundamental issue.

[Cross-posted from Alt‑M.org]