How softies seized the Fed from grasp of the hawkish

Who should lead the Federal Reserve? President Joe Biden faced a difficult choice. Should he reappoint Jay Powell, a monetary dove who believes the current inflation spike is probably temporary but might revise his views in the light of evidence? Or should he nominate Lael Brainard, a monetary dove who believes the current inflation spike is probably temporary but might revise her views in the light of evidence?

OK, Powell and Brainard aren’t identical. Powell is or was a Republican, Brainard is a Democrat; Brainard took a harder line on financial regulation after the 2008 crisis, which is why progressives like Elizabeth Warren opposed Powell’s reappointment. But when it comes to the Fed’s core responsibility, setting monetary policy, there was never any doubt that the next chair would be someone reluctant to raise interest rates and eager to keep job growth high.

The Fed is a technocratic institution that takes ideas and analysis seriously, that is willing to revise its views in the light of evidence. On the eve of the 2008 crisis it believed, with considerable justification, that giving low inflation priority over other considerations was in fact the right policy.

Since then, however, there has been accumulating evidence that targeting inflation isn’t enough.

The story here begins with a famous 1968 speech by Milton Friedman (and an independent analysis by Edmund Phelps that reached similar conclusions). Friedman argued, contrary to what many economists believed, that monetary policy couldn’t be used to target low unemployment on a sustained basis. Any attempt to keep unemployment below its “natural rate” would, he asserted, lead to ever-accelerating inflation, and it would take a period of high unemployment to get inflation back down.

If you accepted this “accelerationist” hypothesis, the Fed’s job wasn’t to keep unemployment low, because it couldn’t do that. It was, instead, merely to provide stability in prices and employment.

But here’s the thing: Since at least the mid1990s, the data haven’t looked anything like that.

Notably, unemployment dipped below 4% at the end of the 1990s and the 2010s, in each case without provoking accelerating inflation, while even very high unemployment after 2008 failed to produce the deflationary spiral Friedman-type analysis would have predicted.

And if low unemployment doesn’t lead to accelerating inflation, it seems all too likely that we have consistently been running the economy too cold, sacrificing jobs and output unnecessarily.

There’s also another consideration that has made the Fed more dovish: fear that the effects of tight money may prove very hard to reverse.

Back in 1935, Mariner Eccles, another Fed chair, argued the Fed could do little to reverse deflation because you can’t push on a string. This made sense at the time. The Fed had little ability to cut interest rates, because they were already near zero.

As it turns out, however, interest rates can indeed hit the “zero lower bound”; in fact, that has been the norm since 2007.

This in turn means that while everyone is talking about inflation risks now, the Fed is also concerned about overreacting to inflation. If it raises interest rates and that pushes the economy into a recession, it might not be able to cut rates enough to get us out.

So if you ask why monetary doves rule the Fed roost, it’s not just a matter of personalities — or ideology. The past couple of decades have highlighted the downsides of hawkishness, and the Fed doesn’t want to repeat what it now views as past mistakes.