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The debate we should be having about the Federal Reserve

Greg Nash

The selection of the next chairman of the Federal Reserve has generated far more attention than it deserves. Political leaders should instead be engaging in a far-reaching debate about the fundamental direction of U.S. monetary policy. Whether Jerome Powell deserves to be reappointed or replaced by Lael Brainard might be an intriguing debate for D.C. insiders, but the choice is likely to be of little consequence, given the similarities in their economic outlooks and policy prescriptions. Furthermore, the selection of a chairman is largely moot as today’s Federal Reserve (Fed) is a far more democratic institution than the one overseen by Alan Greenspan.

The Greenspan era was famously characterized as being one in which the chairman systematically attempted to influence the preferences of voting members of the Federal Reserve Open Market Committee (FOMC) in order to achieve near unanimous consensus. Under the leadership of Ben Bernanke, Janet Yellen and Powell, the Fed has shifted away from being overly reliant on the views of the chair. Nowadays, it is hard to imagine a chairman having the same level of influence on his colleagues as Greenspan had during his long and controversial tenure. 

Looking beyond the Fed Chair selection debate, there are three critical issues that should be of grave concern for policymakers, as they are likely to impact the ongoing recovery and influence the long-term trajectory of the U.S. economy. These fundamental matters should be at the center of the ongoing political debate regarding the role of the Federal Reserve and its approach to monetary policymaking.

First, the nature and scope of supply shocks hitting American businesses appear to be far more severe and longer lasting than the Fed anticipated. The case made by Powell and his colleagues for inflation being transitory largely rested on the assumption that supply constraints would be quickly resolved once worldwide production came back online and transportation bottlenecks disappeared. Recent developments, however, suggest that it will take much longer for supply shocks to dissipate. There may even be some lingering effects that have the potential to generate persistent upward pressure on price levels.

The 21st century global supply chain, while incredibly efficient and cost-effective, was not built for dealing with rolling waves of COVID-19 surges and associated lockdowns; nor was it set up to handle increasingly frequent extreme weather events and climate change-related catastrophes. Even prior to the pandemic, the Trump trade wars highlighted the risks associated with a China-centric global manufacturing supply chain.

Going forward, it is likely that greater emphasis will be placed on building more diversified and more resilient supply chains, which will result in higher future production costs. Furthermore, the pandemic shock has highlighted the downside of lean inventories and just-in-time ordering. Fundamental reorganization of production processes and inventory management techniques are likely to lead to a sustained period of higher prices. 

A second critical issue is related to the Fed’s implicit assumption that running the economy hot in order to attain “maximum employment” poses limited downside risks. The pandemic shock and resultant changes in the underlying structure of the economy is bound to complicate “determination of maximum employment” levels. The emergence of remote/hybrid work options and massive sectoral demand shifts indicate a labor market that is in the throes of significant transformation.

Recent trends in the U.S. labor market – reassessment of work, high quit rates, record number of job openings and rising mismatches – point to a period of elevated frictional and structural unemployment, which is likely to result in the natural rate of unemployment exceeding its pre-pandemic level. 

Consequently, attempting to reach the historically low unemployment rates last seen in February 2020 may result in a Fed policy error that raises inflation expectations. It is also unclear that running the economy hot will necessarily result in improved outcomes for marginalized groups.

A third area of concern relates to financial distortions associated with the injection of excess liquidity via prolonged periods of quantitative easing by the Fed and other major central banks. Measures originally intended for financial emergencies are now being deployed by monetary authorities to achieve traditional macroeconomic goals. This in turn has caused financial markets to become addicted to a never-ending stream of easy money to sustain ever higher asset prices. Unsurprisingly, it has also encouraged speculative excesses. Unconventional Fed policies might unintentionally be contributing to a rise in inequality.

The real debate therefore should be about the efficacy of pursuing ultra-accommodative monetary policies when the economy is facing supply constraints and rising inflationary pressures. The logic of buying mortgage-backed securities when home prices are setting monthly record highs is hard to fathom. The Fed’s decision to stick with bond purchases is difficult to rationalize when the 10-year Treasury note yield languishes around 1.3 percent. The reach for yield by desperate investors has encouraged record issuance of junk bonds.

Have recent Fed policies pushed us into a debt trap that limits the central bank’s ability to raise interest rates in the future? With historically high levels of public debt and non-financial corporate debt, any significant monetary tightening will result in a rapid collapse of asset prices and a sharp economic contraction, necessitating a quick return to ever larger amounts of fresh liquidity injections and further expansion of the central bank balance sheet.

Unless we get extremely lucky and a whole host of challenging issues get favorably resolved, the next Fed Chair and his/her colleagues are going to face some unpleasant choices.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.

Tags Alan Greenspan economy Federal Reserve Federal Reserve System FOMC Inflation Jerome Powell Lael Brainard Monetary policy Monetary policy of the United States Quantitative easing

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