My mentor, the late George Shultz, often said, “An economist’s delay is a politician’s nightmare”. It takes several quarters for economic policy changes to affect the real economy. Politicians are usually not that patient.
The Federal Reserve announced a new monetary policy doctrine almost a year ago. In essence, the Fed said it would no longer allow for delays in monetary policy and abandon the “pre-emptive” policy that was standard among Fed leaders Paul Volcker, Alan Greenspan, Ben Bernanke and Janet Yellen. Jerome Powell’s Fed believes the party is just beginning and won’t remove the punch bowl until the fun is in full swing and the neighbors know. Most in Washington can hardly contain their enthusiasm for the new doctrine. Wall Street loves it too.
However, optimism for the future should go hand in hand with memories of the past. Real economic growth is growing faster than in the Reagan years. US government spending has grown fastest since World War II. The real estate market is running hotter than in the run-up to 2008. The financial markets are stronger and broader than during the dot-com boom at the turn of the century. And economic output will soon surpass historic highs.
The Fed might be right. The rise in prices and wages could be temporary. The widespread anecdotes of labor shortages and significant wage increases may not represent a sustainable trend. Inflation expectations may be stable. Count me skeptical of the Fed’s beliefs. The risks the Fed is taking in its winning forecast are substantial, and the consequences of monetary policy errors are grave.
The Fed’s new doctrine is a catalyst for heightened concern. When it was announced in Jackson Hole in August, the aim of the new Fed doctrine was actually to dissolve inflation expectations, which had supposedly been too low for too long. Anchoring expectations back – a little higher, but not too much – is a far more difficult task, especially amid the changing seas of post-pandemic economic boom.
No other major central bank has adopted something like the Fed’s new framework. The People’s Bank of China has already lifted significant provisions. The Bank of Canada announced sensible steps towards normalization. The Bank of Korea expressed interest in a somewhat tighter policy. I expect that other central banks in the group of 20 will move further away from Fed policies in the coming months.
Illustration:
David Gotthard
The resulting US dollar weakness – underway since last fall – harbors a number of dangers, including the risk of inflation. The Fed says it has the tools to stop a surge in inflation, but its new regime promises a belated response. Deliberately too late, the Fed would have to tighten its monetary policy further in order to stop a surge in inflation.
Inflation is hardly the only or predominant monetary policy risk. The level of government spending and activity is unprecedented. Since the pandemic began last February, the Fed has bought 56% of total $ 4.5 trillion in US Treasury bond issues. The Fed’s security purchases account for 76% of the federal cumulative budget deficit. And the Biden government is proposing a budget of $ 6 trillion for fiscal year 2022, about a third of which would not be funded.
The Fed says it’s too early to slow its purchases of government bonds and government-backed housing debt. If the Fed doesn’t act immediately, it may be too late. Others will fund the nation’s wastefulness even as economic growth slows and the debt burden increases. But what rate of interest will investors charge for the privilege?
Most of the large overseas buyers, including China, left the Treasury Department’s auction market when the pandemic struck and have made no meaningful return. Lots of foreign companies believe the Fed is monetizing the fiscal expansion and expects the new monetary policy experiment to end badly. The leaders in China are ready to capitalize on an American policy error.
Other investors see the increasing tensions between East and West and are hedging their bets. The excitement at the recent China-US meeting in Anchorage was just a prologue. The Biden administration may wonder if, in the absence of Fed intervention to keep interest rates exceptionally low, it can rely on the kindness of strangers to fund its grand ambitions.
I fear that the Fed has subscribed to a monetary “Brezhnev doctrine”. Leonid Brezhnev, the leader of the Soviet Union at the height of the Cold War, made it clear that once another country has embraced communism, it must never return. It was more important for Moscow to maintain the appearance of infallibility than to adapt to changing circumstances. Dissent was strongly discouraged. Ultimately, the Brezhnev Doctrine drained the Soviets economically until the system could no longer be sustained. And it ideologically drained the system, leaving a dangerous void in the aftermath.
During the darkest days of the pandemic, Mr. Powell proved to be a nimble and capable crisis manager. But the crisis for which the Fed’s emergency tools were developed is long over. The “V” shape of the economic recovery matches its immediate cause, the vaccine.
The Fed risks going through a one-way door. Mr Powell’s performance at the next press conference – speaking exactly the right words in practiced, measured tones – is of little importance. Talking about tapering is a sideline, albeit in public. What matters most now is what the Fed does, not what it says.
The Fed should change its monetary policy regime. You should stop buying mortgage securities immediately. Soon after, it was supposed to slow down its government bond purchases. It should not tolerate a fiscal expansion funded by the Fed. It should loosen the handcuffs imposed by its novel doctrine and make an informed and humble judgment about the state of the economy and the risks it poses to prospects.
Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting scholar in economics at Stanford University’s Hoover Institution.
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