The truth is that the Fed gets too much credit when things are good and too much blame when they’re bad.
Outdated ideas spell trouble for the Fed in 2023.
I t’s hard to shake the feeling that former New York Fed president Bill Dudley’s recent Bloomberg column — “What Could Go Wrong for the Federal Reserve in 2023?” — is a testament to nearly everything that is wrong with how federal officials view monetary policy. There’s no reason the folks running the Fed can’t change course, and folks like Dudley could — and should — help push policy in a better direction.
Dudley worries one of the biggest risks the Fed faces is that “economic growth could prove more persistent than expected.” More economic growth is a risk? The implication, of course, is that more economic growth will lead to more inflation, making it more difficult for the Fed to “push the rate of inflation back down.”
The problem is that economic growth does not, by itself, result in higher inflation. On the other hand, the Fed’s shooting for a constant rate of “slow but steady” inflation does result in higher inflation. So, too, does expansionary fiscal policy in a world with resource constraints (also known as reality).
To his credit, Dudley acknowledges the expansionary-fiscal-policy problem. But to the extent the Fed must deal with that reality, Fed officials should be screaming at Congress to stop counteracting monetary policy. It makes little sense to deliberately set up a system that leaves the Fed with no choice but to battle Congress. It makes even less sense given that all the Fed can really do is try to restrain credit growth for the whole economy.
Another of the most problematic aspects of policy that Dudley reveals is the long-running fascination with the Phillips curve, the supposed tradeoff between inflation and unemployment. Dudley worries that “to drive wage inflation down to a range of 3% to 4%” will “require” smaller job gains and “a rise in the unemployment rate to at least 4.5% to 5% from the current 3.7%.”
Despite all the discussion the Phillips curve earns in conversations about the Fed, few economists still believe that there is a long-run tradeoff between inflation and unemployment. As for any short-run tradeoff that might exist, it is at best highly unstable. Long periods of history, including the so-called Great Moderation and the aftermath of the 2008 financial crisis, have demonstrated that both inflation and unemployment can fall and remain low despite the monetary authority’s best efforts.
Yes, some economists still debate the usefulness of the Phillips curve for monetary policy, but the debate is probably not what most people think. Without getting too technical, it revolves largely around what economists call the non-accelerating inflation rate of unemployment (NAIRU). But here’s the catch: There’s no controversy over the fact that the NAIRU isn’t stable, and it varies with changes in real factors (union bargaining, demographics, etc.) upon which monetary policy has little if any short-term effect.
The Fed itself knows better. There’s no shortage of Fed officials who acknowledge there is ample evidence to abandon the Phillips curve. The problem is really a political one because the Fed’s dual mandate from Congress has included employment factors since the 1970s. The political prospects are not good for changing that mandate, but that doesn’t make the situation any less frustrating.
The truth is that the Fed gets too much credit when things are good and too much blame when they’re bad. All monetary policy can really do is influence the long-run nominal value of the economy, and that’s what should drive the Fed’s operations.
Until Congress deals with that reality by changing the Fed’s mandate, the answer to Dudley’s question of what could go wrong with the Fed this year will remain “everything.”