The Fed’s Conundrum

I’m seeing an increasing number of articles making the same points as Judy Shelton does in her recent Wall Street Journal op-ed:

Begin with the Federal Reserve’s most pressing challenge: inflation. Gasoline prices, which account for 4% of the overall consumer-price index, had already increased in the 12 months to December 2021 more than any other good or service in the CPI basket—some 51% for regular unleaded gas at the pump. The war in Ukraine, and the West’s response to it, will drive dramatic further increases in energy prices and push the CPI even higher.

Prolonged financial-market uncertainty caused by “geopolitical risk” could be as damaging to the American economy as rising inflation. Uncertainty increases rapid trading moves and rattles stock, bond and commodity markets. In combination with already-frayed nerves over pending interest-rate hikes and continuing supply-chain issues, the opportunity to sow market instability grants Vladimir Putin a degree of leverage over American economic prospects.

A 2018 discussion paper prepared for the Fed Board of Governors defined geopolitical risk as “risk associated with wars, terrorist acts, and tensions between states that affect the normal and peaceful course of international relations.” The study concludes that “exogenous changes in geopolitical risks depress economic activity and stock returns in advanced economies, most notably in the United States.” Importantly, the analysis points out that “these adverse effects are sparked by heightened threats of adverse geopolitical events, rather than their realization.”

and

Two options for reducing inflation through higher interest rates are available to the Fed: raising its administered rates or selling some of its balance-sheet holdings. The former approach would benefit commercial banks by paying them a higher rate of interest on the reserve balances they hold in depository accounts at the Fed. Money-market funds would also earn more interest on overnight reverse-repurchase agreement balances. The funds used by the Fed to pay interest on these balances come out of its own portfolio earnings, which are otherwise remitted back to the Treasury as revenue to the federal budget. American taxpayers might wonder why commercial banks, including the foreign-owned, should collect higher interest on money sitting idle at the Fed.

It would be better if the Fed engaged in more traditional open market operations, reducing its trove of Treasury securities ($5.7 trillion) and mortgage-backed securities ($2.7 trillion)—not only to increase their supply to the market but also to reduce the Fed’s own footprint in financial markets. The Fed’s massive purchases of government-backed securities, more than $4.5 trillion since March 2020, have obscured price signals and distorted investment returns; its holdings should be downsized.

As the graph at the top of this page indicates, increasing oil prices are, at the very least, contributing factors to recession and some have even suggested they are causative. While I recognize that Dr. Powell must be sorely tempted to postpone taking steps to curb inflation while the Biden Administration for its part must be tempted to take steps to ease the pain that inflation is causing, I think that what is needed both economically and politically is coordination between the Federal Reserve and the Administration of a sort that hasn’t been seen in, well, ever. The Fed should take steps to curb inflation; the Administration should take what steps it can to increase domestic oil production and above all not aggravate the situation.

Simultaneous recession and inflation would be no fun at all. I doubt there is anything that will help the Administration more in the coming midterm elections than reducing inflation and stabilizing the price of oil would reduce the likelihood of recession while weakening President Putin’s hand.