Has the central bank learned anything from the painful bubbles of recent past?
Has the central bank learned anything from the painful bubbles of recent past?
R udi Dornbusch, the late MIT economist, once said of the Mexican Central Bank that he could understand its making policy mistakes. After all, its board members were only human. What he could not understand, however, was how it could keep repeating the same policy mistakes time after time.
One wonders whether something equally damning might not be said of Jerome Powell’s Federal Reserve, which has allowed both consumer price inflation to surge to almost 8 percent (a 40-year high) and bubbles to form in the equity, housing, and credit markets. One can perhaps understand Powell’s Fed having made one major policy mistake. That it has made a series of major policy mistakes that has led us to our current economic situation is more difficult to appreciate.
Among the more egregious of these mistakes was not remembering what years of experience have taught economists about monetary policy — namely, that it operates with long and variable lags. This lapse of memory induced the Fed to wait to see inflation rise to a level significantly above the Fed’s 2 percent inflation target before even thinking about moving to a more-restrictive monetary-policy stance.
In March 2021, it also induced the Fed to ignore Larry Summers’s prescient warning that President Biden’s $1.9 trillion American Rescue Plan would lead to economic overheating by year’s end. Despite that warning, the Fed made no change to its ultra-easy monetary-policy stance in anticipation of the inflation that was to come.
The net upshot is that even now at a time when inflation is running at around 8 percent, the Fed’s policy interest rate is stuck at between one-quarter and one-half percent. It would be a gross understatement to say that the Fed has allowed itself to fall well behind the inflation curve.
The Powell Fed also seems to have forgotten Milton Friedman’s famous adage that inflation is always and everywhere a monetary phenomenon. That lapse caused the Fed to turn a blind eye to the explosion of the money supply under its watch. According to the Federal Reserve Bank of St. Louis, since the onset of the pandemic in early 2020, Powell’s Fed has allowed the broad money supply to increase by around 40 percent — by far its fastest pace in the past 50 years. And yet the Fed seems to have been taken by surprise by the return of inflation.
One also has to wonder what, if anything, Powell’s Fed might have learned from our painful experience in 2008 with the bursting of the U.S. housing and credit-market bubble. Had it learned anything, throughout most of last year would it have really continued buying $120 billion a month in U.S. Treasury bonds and mortgage-backed securities at the very time when both the housing and equity markets were on fire?
As a result of the Fed’s aggressive bond-buying activity, by the end of 2021, U.S. equity valuations reached nosebleed levels experienced only once before in the past 100 years. Meanwhile, U.S. housing prices well exceeded their 2006 peak even in inflation-adjusted terms, and interest rates in the highly leveraged loan market dropped to very low levels.
The mistake-ridden Powell Fed now finds itself in the most unenviable of policy positions. Not only is it confronted with a four-decade-high inflation level. It also has an equity, housing, and credit-market bubble on its hands.
Judging by the recently released minutes of its last policy meeting, the Fed seems to be readying itself for yet another major policy mistake by slamming on the monetary-policy brakes too hard. According to those minutes, beginning in May, the Fed is planning to raise interest rates in 50 basis-point increments rather than in 25 basis-point steps, in addition to reducing the size of its balance sheet over the next year by $95 billion a month.
A basic point that now seems to be escaping the Fed’s attention is that today’s everything bubble has been premised on the mistaken assumption that interest rates would remain ultra-low forever. By raising interest rates and by committing itself to rapidly run down the size of its balance sheet, the Fed could very well trigger the bursting of those bubbles.
As occurred in 2008 after the bursting of the U.S. housing and credit-market bubble, the bursting of today’s everything bubble could precipitate a deep economic recession. That in turn might again unleash strong deflationary pressures in its wake that might again force the Fed to abruptly change course. If that indeed occurs, we will have yet another Fed mistake to add to the list.