The New Paradigm

In a Wall Street Journal op-ed Judy Shelton criticizes the present stance of the Federal Reserve Open Market Committee:

Chairman Jerome Powell seems eager to urge patience on raising interest rates for the sake of increasing labor participation. This approach reflects lessons learned about economic growth during the Trump administration, but changed conditions render it inappropriate for the current moment.

It isn’t that the framework is faulty. To the contrary, it incorporates the realization that low unemployment combined with productivity gains isn’t inflationary because it results in increased output. This contradicts the Phillips-curve notion that low unemployment leads to high inflation—which central banks must then counter by raising interest rates.

The Fed’s review of its monetary-policy framework leading to its current approach was conducted over the 18 months before the pandemic began in early 2020. The timing was unfortunate, as the review encompassed the extraordinarily high-growth, low-unemployment, low-inflation environment of 2018-19. Mr. Powell’s mistake now is to ignore the changed circumstances stemming not only from the pandemic but also the Biden administration’s tax and regulatory changes.

If the Federal Open Market Committee, which determines monetary policy, insists on disregarding the structural effects of different administrations’ economic choices, it risks serious error. You can’t make good decisions by following an outdated paradigm.

The Federal Reserve, famously, has a dual mandate: maintaining stable prices and maximizing employment. There is actually a third: regulating banks. Based on the available information how would you explain the Fed’s actions over the last half dozen years:

1. The Federal Reserve governors have abandoned their statutory responsibility to maintain stable prices, first reinterpreting it as to maintain a stable rate of increase in prices (first derivative), and now as to maintain a stable acceleration in prices (second derivative). That’s an obvious abrogation of their responsibilities. Note that they’re not achieving any of those objectives.
2. The Federal Reserve governors have succumbed to a temptation very strong for macroeconomists—ignoring the role of microeconomics in the behavior of the economy. This is manifest in the governors not believing that fiscal policy matters. That is apparently Dr. Shelton’s view.
3. The Federal Reserve governors think they can promote higher labor force participation by keeping interest rates too low for too long. That is the explanation Dr. Shelton expresses in the op-ed. Precisely how this is supposed to work is unclear to me. It’s a weird upside down and backwards version of the Philips Curve.
4. The Federal Reserve governors think that banks are in such a fragile state even more than decade after the financial crisis that they must maintain interest rates as low as possible for as long as possible and similarly retain bank subsidies. What do they know that we don’t know?
5. The Federal Reserve governors think their job is to ensure that the DJIA goes up.
6. They think the only way they can keep their jobs is to keep not doing what they’re not doing.
7. They don’t want to be seen as undermining the Biden presidency.

I’m open to other explanations but those seem the most likely to me.

I feel that I should point out that there is no exemption in the Fed’s empowering legislation for “transitory” inflation or unemployment and under the circumstances I find their behavior bizarre. That’s why I lean to D with a side order of E. I also think they’re ignoring the principles of deterrence. There’s nothing like raising interest rates to convince people that you have the will to raise interest rates.