Federal Reserve Can’t Fix Inflation, Supply Chain Crisis, Unemployment

A year ago,


Federal Reserve

Chair Jerome Powell enjoyed near-universal praise as “The World’s Best Bureaucrat.” The former private-equity executive was cheered for leading the central bank’s unprecedented efforts to stabilize the financial system and prop up the global economy amid the pandemic. But a lot has changed since then: This fall, it seems everyone — politicians, activists, and economists — has questioned Powell and the Federal Reserve about the future of their massive experiment. With inflation measures spiking to 30-year highs in October, the pressure on Powell has only mounted.

The sharp questions are understandable. Since the 2008 financial crisis, the Fed’s power has swelled, and over the past year and a half, it has pumped an eye-watering amount of money into the financial system. Now inflation is biting into the economic recovery, and projections for gross domestic product and employment growth are getting less encouraging. 

Even the programs that the Fed was praised for — bond buying and low interest rates  — are now attracting concerns that the Fed is driving the soaring prices of stocks and exacerbating wealth inequality.

It doesn’t help that the central bank is simultaneously being rocked by an ethics scandal regarding personal trading by senior officials and drawing criticism for walking back regulations designed to make banks safer after the financial crisis. Even climate activists are taking shots at the Fed for not doing enough to help speed the financial system away from fossil-fuel investments

But all of the hullabaloo around the Fed, some deserved and some not, is ultimately driven by the same phenomenon. These policymakers, economists, activists, and even the media have come to see the Fed as the country’s sole economic savior — the only answer to the things that ail us. But as powerful as the Fed has become since the 1970s, the central bank as we know it has run up against the limits of its power — if it even had as much power as we thought all along. And this overreliance on the Fed shows just how far America’s policy muscles have atrophied. 

Instead of piling all of the nation’s problems on the back of Jay Powell, companies, households and workers need other institutions — most notably Congress — to step up and take on their share of the economic problem-solving. To deal with price rises and inequality, legislators can’t just defer to the Fed; they have to get their hands dirty and intervene in the real economy.

Not-so-great expectations

We expect a lot from the Fed. But at the core of these expectations is that the central bank will keep prices rising slowly without soaring out of control. But what if our ideas of the Fed’s supposed almighty power to control inflation are based on faulty thinking? What if other parts of our government actually hold the lever for dealing with sudden price increases, like what we’re seeing in the post-COVID economy? And what would that mean for how we think about the Fed’s power more broadly?

Before answering those questions, let’s review how the Fed is supposed to manage inflation. Primarily, the Fed controls prices by helping money flow around the economy, either by buying bonds or lowering interest rates, and reining it in when the economy looks as if it’s running too hot, usually by ceasing bond purchases and raising rates. These policy moves, especially the efforts to cool the economy, are supposed to discipline American businesses and consumers from lending and spending in a way that would trigger runaway inflation. But now the narrative of the all-powerful, inflation-managing Fed is being called into question. 

According to the past 40 years of conventional wisdom, the central bank is responsible for keeping a lid on prices by managing expectations about future inflation. When consumers and businesses expect prices to increase in the future, the thinking goes, they rush to buy things before they get more expensive, which increases demand and ends up making the price increases worse. This mechanism is known as “pulling forward” consumption. As prices rise, workers also demand raises to afford necessities, and their employers then jack up prices to offset the increased amount they pay employees. The Fed is supposed to stop this vicious cycle by signaling that it is going to raise interest rates and cut off support for the economy, making consumers more wary of spending, employers less likely to raise wages, and businesses less inclined to raise prices. In this model, the onus for stopping these runaway inflation episodes is put on the Fed. It is forced to make painful decisions that limit people’s income and access to credit, even deliberately increasing unemployment, because we have laid the responsibility for controlling our ideas about inflation at its feet.

Gas station prices

A sign showing gas prices at a station in San Diego, California, on November 9, 2021.

Mike Blake/Reuters


This conventional wisdom was on full display when Republican members of the House Committee on Financial Services questioned Powell at an autumn hearing about the central bank’s pandemic response. The conservative politicians argued that we’re already experiencing inflation and pushed Powell to both rein in these price hikes and suggest that further spending — such as the Democrats’ large-scale welfare and climate package — was problematic.

“With spiking energy prices and bottlenecks in supply chains around the world, there is concern that the rise in inflation may not be as transitory as you originally predicted. Given our economic situation and the fact that Democrats want to pass trillions and trillions more in spending, what makes you believe we will not see sustained higher inflation?” asked GOP Rep. Ann Wagner of Missouri. The implication of Wagner’s question is clear: Democrats’ big plans are going to pour money into the economy and drive Americans into a crazy inflation frenzy — demanding higher pay and spending more on goods in spite of the higher prices. So, Wagner all but asks, shouldn’t the Fed step in and denounce this foolish idea? Shouldn’t the all-powerful Fed make it clear that it’ll be forced to raise interest rates if this happens?  

But Powell was unfazed and responded that the price increases were due to temporary supply-chain troubles, not expectations around excessive government spending. The answer also inadvertently let slip the fact that the Fed might not be all-powerful after all. Even through November, Powell has maintained his commitment not to force harsh monetary medicine on the country while the global economy grinds through its reopening.

The problem, as Powell hinted at and a growing chorus of economists both outside government and within the Fed itself have argued, is that we don’t actually have any good reason to believe the Fed is the supreme inflation controller we thought it was. 

As the Fed economist Jeremy Rudd wrote in a recent paper, there is not actually any empirical evidence for the inflation-expectations narrative that has ruled the Fed’s thinking — and by extension American economic policymaking — for decades. Rudd’s paper ignited a lot of controversy and went as viral as possible for macroeconomic research. The implication was clear: Households and firms don’t actually engage in the kind of “pulling forward” behavior that is supposed to exacerbate inflation in a self-fulfilling cycle. Empirical work Rudd cited suggests that economic actors react after the fact to changes in supply and demand arising in their particular corner of the real economy, rather than anticipating changes to general price levels. So the Fed’s efforts to “anchor” inflation expectations across the economy by tinkering with the global supply of dollars might ultimately have little effect on actual prices, except to cut off credit and thus employment to drive consumer demand lower, or to pump out emergency cash during a financial crisis. 

Rudd’s study was also complemented by a piece of historical analysis released by the left-leaning think tank Employ America. The authors, Gabriel Mathy, Skanda Amarnath, and Alex Williams, argued that our current fight with inflation can’t actually be solved by using 1970s Fed action — that simply jacking up interest rates won’t work this time. The trio pointed to the early 1950s as evidence, when inflation spiked as the country mobilized for the Korean War and then melted away without the Fed resorting to higher interest rates.

Similar to today, the 1950s price increases were driven by an external shock that created a mismatch between the supply of labor and materials and the country’s demand: the Korean War. This inflation surge was not driven by a generalized sense that wages and prices overall might rise in a feedback loop but rather a sudden, dramatic shock that took time to work itself out. Instead of raising interest rates and choking off the civilian economy, Congress stepped up and invested in the processes needed to meet the increased demand. Eventually the situation worked itself out as the war ended and the demand for war materials and labor cooled off.

This model — a Congress willing to deal with inflation through fiscal policy that manipulates supply and demand without the need for the Fed to choke off the economy — helped protect employment rather than raising interest rates and stifling growth.

The 1950s fight against inflation also mirrors where we are today. The Fed’s toolbox for fighting inflation that we’ve relied on since the 1970s — raising interest rates or cutting off bond purchases — won’t address current sources of inflation like supply-chain backups, a labor force still too wary of the pandemic or lacking in child care to completely return to work, a shortage of new homes, or an unprecedented shift in consumption away from services and toward goods.

Shipping containers piled high



Getty Images/Sasin Tipchai


Tackling the current rise in prices requires real-world investment to get around bottlenecks like new port facilities; domestic manufacturing, public health, and child-care capacity; and a massive home-building program. The Fed can’t do any of that stuff. Only elected officials from the federal to the state and local level have the ability to make these kinds of investments that grow capacity to catch up with demand.

The point is that maybe the Fed’s actions aren’t the be-all and end-all for fighting inflation. And instead of making the central bank use its blunt tools in times like these, Congress and local governments can step up and make the necessary fixes instead. 

What do we expect of the Fed?

The growing turn in inflation thinking is a huge shift, but what does it mean for the Federal Reserve and economic policy more broadly? During the pandemic, the Fed’s monetary policy has been described as “accommodative,” allowing muscular fiscal policy in the form of the CARES Act and other big stimulus packages to do the heavy lifting without having to deal with tight money at the same time. The Fed’s decision to hold down interest rates has been invaluable during a crisis that threatened to turn into a Great


Depression

-level downturn. But the very word “accommodative” suggests, correctly, that the Fed is really a supporting player here, and the protagonist of the recovery was the big fiscal policies — much as the New Deal and World War II mobilization were during the Great Depression. 

After all, as powerful as the Fed might be, it can work only through the banking system and capital markets. The central bank can’t directly intervene in the real economy or specifically direct money and capital to adjust to radical shifts in demand.

Joe Biden Jerome Powell

U.S. Federal Reserve Chair Jerome Powell listens as President Joe Biden nominates him for a second four-year term in the Eisenhower Executive Office Building’s South Court Auditorium at the White House in Washington, U.S., November 22, 2021.

Kevin Lamarque/Reuters


Think of the Fed like a water authority managing a reservoir. It can release more water to raise the overall flow, but on its own it can’t direct the streams or bring water to where it’s ultimately needed the most. In the event of a flood, it can’t clean up the mess — it can only cut off the water. We need to build irrigation systems and water mains to get the resources where they are needed the most or develop bulwarks against unintended, destructive surges. For decades, though, elected officials have neglected their duty to maintain the country’s economic plumbing — instead just hoping the Fed’s free flow of financial


liquidity

would eventually trickle to the people who needed it. But instead many parts of America have been left out to dry, while the coffers of the richest firms and households are overflowing. Instead of asking the people who have the power to more precisely redirect these resources so supply and demand match up, not to mention fix the gaps between the have and have-nots, the buck has been passed to the Fed to fix everything — from inequality to the climate crisis. This can’t continue. 

Even now experts are once again turning to the Fed to handle this burst of inflation, even though its tools aren’t right for the job. And given the consequences of forcing the Fed to act alone now — a rate-hike-induced economic slowdown when many millions who lost jobs during the pandemic remain out of work — it’s clear the central bank can’t be the savior here: It’s up to the legislators grilling Powell to take the lead.

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