The Humbling of the Federal Reserve The central bank faces an inflation mess of its own making

The central bank faces an inflation mess of its own making 

WSJ editorial. 

"The Federal Open Market Committee meets Tuesday and Wednesday, as it seeks to address the worst inflation in 40 years amid new risks to economic growth. Whatever the Fed decides on interest rates, it’s worth recalling how the central bank arrived at this unhappy moment.

The first reality to confront is that this is a mess largely of the Fed’s own making. The central bank’s inflation target is 2% for personal-consumption expenditure inflation, and the rate in February was probably three times higher. The Consumer-price index is higher still.

Government spending excesses in 2020 and 2021 played a role, but the Fed made all of that easier to pass by maintaining the policies it imposed at the height of the pandemic recession for two more years. Low interest rates make deficits seem more fiscally manageable than they really are. The Fed has continued to buy Treasurys and mortgage-backed securities even as inflation nears 8%—right up until this week’s meeting.

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What went wrong? The Fed is supposed to have the world’s smartest economists and access to the best financial information. How could they make the greatest monetary policy mistake since the 1970s?

Part of the answer lies with the Fed’s economic models, which are rooted in Keynesian analysis in which demand trumps all. The Fed models give little thought to incentives for or barriers to the supply-side. As finance scholar Emre Kuvvet wrote recently on these pages, among economists in the Federal Reserve System, Democrats outnumbered Republicans by 10.4 to 1 in 2021. They prefer James Tobin over Milton Friedman.

This leads the Fed to overestimate the growth effect of federal spending but underestimate the growth benefits of regulatory and tax reform. For years after the 2008-2009 recession, the Fed’s governors and regional bank presidents predicted faster GDP growth than what happened. But they missed the faster growth after the 2017 tax reform.

Another answer lies in what has become a lack of institutional accountability. The central bank was humbled in the 1970s, but under Paul Volcker and Alan Greenspan it revived its reputation as it vanquished inflation and produced the Great Moderation of growth and price stability. The Fed receives the most favorable press coverage in the free world. This has led to a failure to admit mistakes or accept responsibility for its contribution to the mania of the mid-2000s and the panic and crash of 2008.

Mr. Greenspan famously blamed banks for the crash, and Democrats and the press were only too happy to echo the narrative. The Fed’s seminal contribution of keeping rates too low for too long was ignored—except by monetary economist John Taylor and on these pages. Undeserved absolution produced arrogance.

That attitude was reinforced after the Great Recession as the Fed unveiled quantitative-easing and kept interest rates near-zero for years. Critics—including some of our contributors—predicted inflation that didn’t happen. The economic expansion was the slowest in decades and wage gains were weak, but the soaring value of assets kept Wall Street happy.

When the pandemic hit, the Fed returned to the same monetary playbook and expected the same result. Its historic exertions were needed in the emergency. But it kept them in place for too long, even as the money supply exploded and clear signs of inflation began to appear.

Fed economists told Chairman Jerome Powell inflation was “transitory,” because that is what the models said. The Fed kept buying bonds and kept the fed funds rate near zero despite an inflation rate of 7% and a roaring economic recovery from the pandemic.

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Now the Fed has to find a way to bring inflation down without tanking the economy that faces new headwinds—from rising commodity prices, war in Ukraine, and a Congress and White House whose sole economic strategy is spending more money and heaping regulation and taxes on productive businesses.

Lifting off from zero would have been far easier if the Fed had started to do so long ago. Now the task is more complicated. Consumer and small-business confidence has fallen of late, and Americans are spending down their pandemic payment windfalls.

But the rise of inflation psychology among consumers and business gives the Fed little choice other than to start addressing its monetary mistakes. Prices are rising fast and eroding real wage gains, and controlling prices will take fortitude—especially if the economy slows.

But that’s the dilemma the Fed created for itself. Better to get on with it than go down in history as the second coming of Arthur Burns and the 1970s."