How softies seized the Fed

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

In the end, he went with Powell.

There was never any doubt that the next chair would be someone reluctant to raise interest rates and eager to keep job growth high.

How did that happen? Traditionally, central bankers — people who run institutions like the Fed that control national money supplies — pride themselves on their sternness, their willingness to impose economic hardship. William McChesney Martin, who headed the Fed in the 1950s, famously described its job as being to take away the punch bowl just as the party really gets going — that is, to raise interest rates as soon as there was any indication of rising inflation.

But 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 — indeed, that the Fed has consistently been taking away the punch bowl too soon.

The story here begins with a famous 1968 speech by Milton Friedman. Friedman argued, contrary to what many economists believed at the time, 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.

The experience of the 1970s and ‘80s seemed to confirm this analysis.

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 both prices and employment.

But here’s the thing: Since at least the mid-1990s, the data haven’t looked anything like that.

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 chairman, argued that 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 very 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 the 21st century; in fact, that has been the norm since 2007.

This in turn means that while everyone is talking about inflation risks right now, the Fed is also concerned about the risks of 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 again.

Gail Collins’ column returns soon.