Treasury Secretary Janet Yellen’s comments about interest rates triggered inflation fears in many quarters this week. Yet, much like a similar incident last month, what she said really wasn’t anything earth-shattering.
The disappointing part concerning both episodes is that pretty much everyone is engaging in old-school monetary policy debates while ignoring the 21st century risks.
On June 6, Yellen told a reporter:
If we ended up with a slightly higher interest rate environment, it would actually be a plus for society's point of view and the Fed's point of view. We've been fighting inflation that's too low and interest rates that are too low now for a decade. We want them to go back to a normal interest rate environment, and if this helps a little bit to alleviate things, then that's not a bad thing—that's a good thing.
The fact that a career central banker said any of these things should surprise no one. It is pretty much standard economics for any Fed official: interest rates have been “too low” because short-term rates have been close to the zero-lower bound, thus making it difficult to conduct standard monetary policy.
Very low inflation (or expected inflation), this story goes, contributes to ultra-low rates because people require a very low inflation premium when they lend money.
This standard view also holds that extremely low inflation is bad because it portends a collapse in prices (deflation), and because it signifies weakness in the economy due to a lack of consumer confidence (people buy fewer consumer goods when they have little confidence in the strength of the economy). Essentially, very low inflation means that consumer demand is “too low,” thus leading to less economic growth and lower wages.
Of course, when inflation is “too high,” that’s also bad because it can lead to prices that are out of reach for consumers, thus leading to unemployment when businesses can no longer sell their products.
Connecting back to interest rates, this story says that higher rates signify a strengthening economy, where the typical rate of profit has increased.
Thus, in Yellen’s (perfectly standard) view, it is the Fed’s job to ensure that inflation is “just right.” That is, inflation (or expected inflation) should be high enough to keep rates away from the zero-lower bound, and high enough to keep unemployment low – but not so high as to destroy purchasing power and create job losses.
That’s the type of policy that Yellen spent most of her career trying to achieve.
So even though the latest inflation numbers have people a bit anxious, Yellen is not panicked. She feels that inflation (and interest rates) should be a bit higher, and that the Fed can control inflation if it gets “too high.”
Naturally, the fact that it is so difficult to put a number on exactly what represents “too high” has caused a great deal of anxiety lately.
The April CPI report showed the largest 12-month increase in inflation since 2008. This increase followed an extended period of much higher-than-average deficit spending, and it came just months after the Fed announced it would start targeting average inflation (over an unspecified period).
It is hardly surprising, therefore, that Americans worry about the possibility of higher inflation. Even former Clinton/Obama advisor Lawrence Summers has issued multiple warnings about inflation risks, proof that inflation is not merely a partisan political issue.
To be sure, there is not much to argue about regarding high inflation. Janet Yellen, as well as current Fed Chair Jerome Powell, wants to avoid the type of high inflation that damages the economy. That type of inflation, incidentally, remains far from imminent.
So while it may be politically expedient to start drawing attention to the recent price increases, Americans would be much better served if Congress would start addressing the underlying problems that produced the current situation.
For starters, nobody is sure exactly what the Fed will do because Congress gives the Fed so much discretion. The Fed’s mandate requires it to:
maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Yet, Congress does not define key terms in the mandate, such as stable prices, and it allows the Fed to develop its own framework to meet these ill-defined mandates. This arrangement, as well as the mistaken belief that a falling price level is always a bad thing, has arguably done at least as much harm as good.
Now, with inflationary risks higher than they have been in decades, the Fed is operating under a financial-crisis framework that has never been tested in a high/rising inflation environment. That fact alone is cause for concern, and the uncertainty will only grow if interest rates start to rise.
In that scenario, the Fed will have to control inflation by paying large financial institutions hundreds of billions of dollars to sit on reserves. That is a political nightmare, one that will hit at exactly the wrong time.
Congress can help calm fears and improve the economic outlook by fixing these issues.
It can, for instance, hold the Fed accountable for a single mandateto stabilize total (nominal) spending, thus allowing prices to fluctuate (appropriately) with productivity. A growing economy does not automatically produce inflation, and the Fed should not prevent prices from falling when productivity is improving.
Congress can also sharpen the lines between monetary and fiscal policy.
After the 2008 crisis passed, the Fed never normalized its operations. As a result, the Fed now operates a framework where its policy stance is divorced from the size of its balance sheet. That is, the Fed’s framework is designed so that its asset purchases do not automatically create inflationary pressures.
While that arrangement may have had its upside during the 2008 financial crisis, the Fed can no longer rely on its stable price mandate to fend off those calling for the Fed to directly finance government spending. The lack of such a buffer poses a serious threat for future inflation.
Of course, there is also the purely fiscal side of this equation – Congress has increased the deficit in the last few years, but those increases pale in comparison to the long-term structural spending problem caused by entitlements. Congress must get its fiscal house in order.
It would certainly be irresponsible for Fed officials to ignore the recent CPI figures, but there is no reason to think that they are making such a mistake. For now, Congress’ best move is to address the underlying problems that have created today’s economic turmoil.
Fixing these problems is the best way to help avoid future economic anxiety.
This piece originally appeared in Forbes https://www.forbes.com/sites/norbertmichel/2021/06/09/what-congress-should-do-about-21st-century-inflation-risks/?sh=988e886340e5