The Fed’s Amazing Journey
In recent years, the central bank has pushed a record amount of money into the financial system—now, as it finally begins to tighten monetary policy, it may face another obstacle.
In recent years, the Federal Reserve has faced a near-collapse of the U.S. Treasury market, the sharpest recession in U.S. history, an extraordinary surge in public debt, and a lingering disruption of global supply chains. These developments prompted the Fed to push a record amount of money into the financial system, purchasing $5 trillion worth of assets over two years and keeping its interest-rate target at or near zero. This aggressive monetary easing (coupled with substantial fiscal support from Congress) spared the country from a deeper recession and spurred a quick recovery, but it also helped create the highest inflation in 40 years.
All this could make the Fed a political lightning rod. The central bank’s own actions have called into question the reliability of its new inflation-targeting framework and put its balance sheet at risk of taking losses—or being raided by politicians. The Fed’s ability to control inflation in the near term will go a long way to determining whether it can continue to meet its legal mandate of price stability and full employment without political interference.
The ongoing inflation surge represents the most immediate challenge. Starting in April of last year, inflation jumped above its 2 percent target. It continued surging through March of this year, when the consumer price index grew at a rate of 8.6 percent. While inflation has started to ease since then and is poised to drop further, most Americans rate it as the main problem facing the country. Supply-side disruptions—factories closing, clogged shipping ports, a decline in oil production—that trace back to external developments, such as the pandemic or the Russia–Ukraine war, contributed to the rise in the price level. But much of the inflation came from the demand side, juiced by large federal spending packages, particularly the $1.9 trillion American Rescue Plan that President Biden signed into law in early 2021. The chart below, which measures inflation using the GDP deflator price index and the Mercatus Center’s NGDP Gap measure, indicates that the large fiscal stimulus and the Fed’s decision not to offset it in 2021 triggered the recent inflation surge. Demand became the dominant force behind inflation by late 2021, a development the Fed could have minimized had it started tightening monetary policy sooner.
Why did the central bank hesitate? Some observers, such as former Treasury secretary Larry Summers and former New York Fed president Bill Dudley, attribute the inaction to the Fed’s new framework of flexible average inflation targeting (FAIT). These critics believe that FAIT, which allows the Fed to compensate for past misses in its inflation target and to interpret more flexibly its statutory mandate to seek full employment, caused the Fed to hesitate and fall behind the curve. Another possibility is that the pandemic worsened the knowledge problem inherent in inflation targeting. Inflation-targeting central banks can constructively respond only to inflation caused by demand shocks; they therefore need to know the source of inflation. But this knowledge is unobtainable in real time, especially during periods of high uncertainty. That’s why many observers, myself included, have argued that the Fed should target the forecasted path of demand directly instead of targeting inflation itself, which can be misleading.
In any case, the Fed eventually came around. Chairman Jerome Powell has raised interest rates several times, planned further hikes, and begun to shrink the bank’s balance sheet to pull money out of the economy. Financial conditions have significantly tightened as a result. Some worry that the Fed may go too far in tightening, though Fed officials believe they can slow down the economy without causing unemployment to rise. Their ability to engineer such a “soft landing” for the economy may be helped by some good luck: if supply bottlenecks work themselves out, inflation will fall as economic production increases, making it easier for the Fed to keep the recovery going while curtailing inflation.
But another obstacle may prove more problematic: the Fed’s $9 trillion balance sheet. As the central bank raises its interest rate target, the costs of servicing its balance sheet will rise. Currently, the Fed holds $3.3 trillion of bank reserves and $2 trillion in overnight reverse repos. The combined interest payments on these assets grew from $0.9 billion in the fourth quarter of 2021 to $2.4 billion in the first quarter of 2022 based on just one 0.25 percent increase in the Fed’s interest rate target. With multiple subsequent rate hikes of 0.50 percent expected this year, the Fed’s interest expenses are poised to grow dramatically. Lawmakers may get worked up about the large interest payments being sent to financial firms. Higher interest payments, moreover, also mean less money being sent back to the Treasury to pay for the deficit, which could raise further questions.
And what if lawmakers come to see the balance sheet as a piggy bank? If inflation falls, some will insist that the size of the Fed’s balance sheet is independent of the stance of monetary policy and inflation. If the Fed can add $5 trillion to its balance sheet and the inflation surge proves to be ultimately temporary, one might ask, then why shouldn’t lawmakers do more with the Fed’s balance sheet? Why not fund a green transformation of the U.S. economy, for example, or pay off student debt? This possibility, which economist George Selgin calls “fiscal QE,” would pose a serious threat to the Fed’s independence and its ability to maintain price stability.
One way to avoid this would be to reconnect the size of the Fed’s balance sheet to its monetary stance. That would require the Fed to return to a smaller balance sheet and abandon its “ample reserve” operating system so that its asset purchases and sales are once again directly linked to overnight interest rates. Such a transition would probably take some time, given the size of the Fed’s balance sheet. But if the alternative is the further politicization of the Fed, it’s worth considering.
The Fed’s current journey started in early 2020, but it’s not over yet. The latest bump in the road on this expedition, the inflation surge, should be surmountable (and should remind policymakers that targeting demand is usually easier than targeting inflation). The next obstacle—the political dangers posed by the growth of the Fed’s balance sheet—is more worrisome, though it, too, has a fix.
Photo by Manny Ceneta/Getty Images
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