The Need for Federal Reserve Flexibility

Keynes famously said, “When the facts change, I change my mind. What do you do, sir?” In today’s world of heightened geopolitical uncertainty and overextended credit and equity markets, the Federal Reserve would do well to heed Keynes’s advice and be prepared to change its monetary policy outlook at short notice as new facts emerge. There might certainly be times, like now, of rising energy and fertilizer prices when the Fed might need to consider raising interest rates to keep inflation expectations well anchored. However, there might be times later in the year when bursting credit and equity market bubbles require the Fed to quickly loosen monetary policy to help deal with a financial market crisis. In 2021, the Fed responded to the COVID-19 supply-side shock with an overly easy monetary policy. It did so in the belief that the inflation shock would be of a transitory nature. Even as the economy was recovering strongly and inflation was picking up, the Fed kept interest rates at their zero bound, continued its asset purchases at the rate of $120 billion a month, and allowed the broad money supply to increase by 26 percent. The net result was that the Fed’s largesse contributed to inflation reaching a peak of nine percent by June 2022. Armed with that experience, the Fed would be well advised not to repeat the same mistake of pursuing an overly easy monetary policy in response to the current energy and fertilizer price shock in the hope that it will be of a transitory nature. Over the past month, following the closure of the Strait of Hormuz, international oil prices have increased by 70 percent to their present level of around $110 a barrel, while fertilizer prices have increased by over 50 percent. If maintained, those price hikes could lead to US inflation exceeding four percent by the end of this year or double the Fed’s two percent inflation target. With employment still holding up well, the prospective increase in inflation might require the two to three interest rate hikes that J.P. Morgan is suggesting might be needed to keep inflation contained. Another reason why the Fed might need to raise interest rates soon is to quell any notion that the United States will try to inflate its way out of its debt problem. Allowing that notion to take hold could precipitate a bond market crisis as investors demanded higher interest rates to compensate them for the risk of higher inflation. The 50-basis-point rise in the 10-year Treasury bond yield to around 4.3 percent since the start of the year, at a time when US Treasury bonds should have been benefiting from safe-haven demand, should be a reminder of the risk of pursuing an irresponsible budget policy. Even before the Iran war, the country was on an unsustainable debt path. According to the Congressional Budget Office, the budget deficit was set to exceed six percent of GDP as far as the eye can see, while by 2030, the public debt in relation to the size of the economy was set to exceed its level at the end of the Second World War. The need for increased defense spending in the wake of the Iran war threatens to exacerbate an already troubling budget situation, as underlined by Trump’s proposal to increase defense spending by $500 billion. It also strengthens the case for monetary policy caution. In the run-up to the 2008–2009 Great Economic Recession, the Fed was slow to recognize the changing facts in the financial markets that contributed to the worst economic recession in the post-war period. We have to hope that the Fed does not repeat that same mistake later this year, should a spike in long-term interest rates and a slowing in the economy burst the various bubbles now characterizing the US economy. Rather, it should be prepared to cut interest rates aggressively and, if necessary, resume asset purchases to prevent a disorderly bursting of those bubbles. Heightening the risk that bubbles could burst are the strains already apparent in the private credit and commercial loan markets, as well as equity valuations that are still substantially above their long-term average. In addition, higher energy costs and lesser outward investment by the Gulf countries in the wake of the Iran war could cause a cooling of investment in Artificial Intelligence. Over the past year, that investment has been a substantial contributor to US economic growth. All of this is to say that we now live in a world of heightened uncertainty where the economic facts can change at a moment’s notice. In that world, the country would be best served by a Fed that is not wed to preconceived monetary policy ideas but is prepared to make early monetary policy changes when the facts change. The post The Need for Federal Reserve Flexibility appeared first on American Enterprise Institute - AEI .