John Cochrane has a new blog post in which he tries to make sense of the Federal Reserve’s reasoning on monetary policy.
He describes the Fed’s inflation-fighting policy so far as underwhelming:
Inflation has been with us for a year; it is 7.9% and trending up. March 15, the Fed finally budged the Federal Funds rate from 0 to 0.33%, (look hard) with slow rate rises to come.
A third of a percent is a lot less than eight percent. The usual wisdom says that to reduce inflation, the Fed must raise the nominal interest rate by more than the inflation rate. In that way the real interest rate rises, cooling the economy.
At a minimum, then, usual wisdom says that the interest rate should be above 8%. Now. The Taylor rule says the interest rate should be 2%, plus 1.5 times how much inflation exceeds 2%. That means an interest rate of 2+1.5x(8-2) = 11%. Yet the Fed sits, and contemplates at most a percent or two over the summer.
He goes on to look at past Fed actions when inflation has been high. The Fed’s hesitance to raise rates now looks strange compared with the ’70s, for example: “In each spurt of inflation in the 1970s, the Fed did, promptly, raise interest rates, about one for one with inflation,” Cochrane writes.
Despite the conventional wisdom and historical evidence, the Fed this time believes that inflation will begin to cool off on its own, with mild increases in the federal funds rate aiding the slowdown. Cochrane pulls directly from the Fed’s economic projections when explaining that. In other words, even though Jerome Powell has stopped saying “transitory,” it seems that the Fed, as an institution, still believes that the current bout of inflation is not the result of bad monetary policy and is instead the result of other factors outside the Fed’s control (supply shocks, pandemic recovery, etc.) that will resolve themselves independent of the Fed’s policy.
Cochrane is not fully convinced of that story, writing, “To my mind, it’s evident that widespread inflation, including wage increases, comes from demand rather than supply, so I see a large fiscal shock.” But even granting the Fed’s interpretation, Cochrane writes, “a one-time shock, no matter its nature, does not necessarily lead to a one-time inflation. When the shock ends, the inflation does not necessarily end.”
Cochrane then goes through some equations from two models of the economy that yield very different results. Under an adaptive expectations model, which is more representative of the conventional wisdom on monetary policy, inflation would continue to increase when the one-time shock is over. Under a rational expectations model, though, inflation would do roughly what the Fed is projecting: cool off on its own with some modest interest-rate hikes along the way. (He shows his work in the post on how this would happen mathematically.)
In Cochrane’s telling, the Fed is rejecting the current conventional wisdom of the economics profession on monetary policy and embracing a different way of viewing the economy. It’s not behaving recklessly or lacking theoretical underpinnings; it is merely using different theoretical underpinnings than most economists have used in recent years.
We have good reason to rethink conventional wisdom on monetary policy. As Cochrane points out, the adaptive expectations model would have predicted a deflationary spiral because of the Great Recession, which did not happen. Further, some economists predicted higher price inflation due to the Fed’s zero-interest-rate policies after the Great Recession, which did not happen, either.
Cochrane concludes:
Bottom line: In the chorus of opinion that the Fed is blowing it, this post acknowledges a possibility: The Fed may be right. There is a model in which inflation goes away as the Fed forecasts. It’s a simple model, with attractive ingredients: rational expectations. There is also a model, more likely in my view, that inflation persists and goes away slowly — so long as we don’t get more bad shocks — because prices are stickier than the Fed thinks, as outlined in my last post. But, the key, inflation does not spiral away as the standard model suggests. If inflation does not spiral away, despite sluggish interest rate adjustment, we will learn a good deal.
The next few years will be revealing, as were the 2010s.
Cochrane’s post is an example of macroeconomic reasoning done right: relatively simple mathematical models, based on real-world data and economic history, with a heavy dose of epistemic humility. The entire post, with graphs that aid his explanation, is worth your time (link again here).