About the author: J.W. Mason is a professor of economics at John Jay College, City University of New York, and a fellow at the Roosevelt Institute.
To careful listeners, there was something tragic about Federal Reserve Chair Jerome Powell’s press conference on Wednesday. It was the sound of a man who has been given a job he knows is impossible, but who feels duty-bound to go on regardless.
Perhaps the most revealing moment came when a sharp-eyed Matthew Boesler of Bloomberg noted the disappearance of a line found in earlier statements issued by the Federal Open Market Committee. Before, they’d said that a return to 2% inflation was consistent with continued strong labor markets, but no longer. Did that mean the Fed was now planning on a recession?
Well, replied Powell, it still might be possible to bring down inflation without a recession. But, he added, “those pathways have become much more challenging due to factors that are not under our control … [like] the fallout from the war in Ukraine, which has brought a spike in prices of energy, food, fertilizer, and industrial chemicals, and also supply chains more broadly… That sentence says on its face that monetary policy alone can do this. And that just didn’t seem appropriate.”
This was the key moment. The Fed chair acknowledged that current inflation is mainly due to factors that have nothing to do with U.S. credit conditions.
In effect, we’re looking at a job that calls for a sewing machine, or maybe a fire extinguisher, when all Powell has is a hammer. But as the rest of the press conference made clear, he plans to go on swinging it.
Let’s take a step back. Today’s macroeconomic orthodoxy puts economic management in the hands of the central bank, which relies mainly on a single instrument, the overnight interest rate between banks. This arrangement is based on a certain model of the economy. In this model, the supply side—the productive capacity of a country’s labor and businesses—grows at a stable pace. Spending, meanwhile, may run ahead or fall behind, depending mainly on developments in the financial system. Asset bubbles may raise desired spending beyond what the economy is able to produce, as businesses take advantage of cheap financing and households of their paper wealth. Bank failures may cut off credit, pushing spending below potential.
If these assumptions hold, then it makes sense that the institution that sits at the apex of the financial system is also the one that manages macroeconomic imbalances like inflation or unemployment.
But the assumptions may not hold. Macroeconomic disturbances may come from the supply side rather than the demand side. Demand may fluctuate for reasons unrelated to finance. Supply and demand may not be independent of each other. Depressed demand can discourage capacity-boosting investment, while strong demand can encourage it.
In these cases, the Fed’s power over the financial system may not be enough to stabilize the economy. Efforts to offset supply disruptions by adjusting the flow of credit somewhere else may fail to address the underlying problems, or even make them worse.
Until recently, the Fed seemed to think that current inflation was the kind of problem it was set up to solve. Statements earlier this year described rising prices as a symptom of too much demand and of labor markets that were “tight to an unhealthy level.” Higher interest rates would moderate demand for labor, with slowing wage growth getting passed on to slower prices. As recently as May, the stated goal was to “get wages down.”
But now, Powell has more or less admitted he was aiming the wrong way. In another striking moment from the press conference, he said, “Wages are not principally responsible for the inflation we’re seeing.” This judgment is consistent with what other economists have found. But it raises the question: If wages aren’t what’s driving inflation, why are we addressing inflation with tools that act mainly on wages?
Today’s inflation is not about an overheated economy at all, it turns out. It is mainly due to global factors. Among the rich countries, the U.S. stands out for the scale of its stimulus spending over the past two years. But its inflation performance is close to the middle of the pack. As Powell himself noted, “Lots of countries are looking at inflation of 10%, and that’s largely due to commodity prices.”
Energy prices in particular, which seemed to have stabilized by the end of 2021, have marched upward since Russia’s invasion of Ukraine. This contributes, perhaps more than anything else, to the sense of panic around inflation. And yet as the chairman says, “Gas prices are … not something we can do anything about.”
What the Fed can do is discourage new housing construction (housing starts fell 14% in May), in the long run making housing more expensive, not less. What the Fed can do is shift bargaining power in the labor market from workers to employers, causing wages to fall even further short of the cost of living. What the Fed can do, if it pushes hard enough, is tip the economy into recession.
As the press conference made clear, Powell knows perfectly well that none of this will address the real sources of rising prices. But it’s his job, and he intends to go on doing it.
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