Why monetary policy has become so difficult

Today’s column is not about what the Federal Reserve or its counterpart, the European Central Bank, should do.

I have opinions, of course:

If it’s worth it, I think powered is doing more or less well and the ECB is exaggerating.

But this is a huge and unfinished debate; in fact, it may never be fixed, as people are so good at convincing themselves that they are right.

Instead, I want to focus on why each central bank’s job seems so challenging right now:

because every institution seems to be faced with compromises distressing.

Background:

for a while, inflation seemed to be an American problem.

Yes, prices were rising in Europe as well, but not as much as in the US, and the ECB, unlike the Fed, was not talking about raising interest rates.

Recently, however, European inflation has risen to the point where it is substantially so tall like US inflation

This has led to some strange twists and turns in the inflation debate.

Some economists point to European inflation as proof that US deficit spending has never been to blame, that inflation is driven by global forces beyond the control of the Biden administration.

In response, those who blame US inflation for overspending are making exactly the same arguments about Europe that Team Transitory used for the US:

core inflation remains low, these are temporary shocks due to the recovery from the pandemic, the war in Ukraine, etc.

This is not, by the way, a discovery.

Economic models should reach different conclusions in different circumstances.

But it’s still fun.

However, I doubt it Jerome Powell, Fed Chairman, o Cristina LagardePresident of the ECB, you find the situation amusing.

Both face painful decisions.

nobody knows for sure How bad is it it is the inflationary threat it faces and therefore what is needed to cool their respective economies.

Neither Powell or Lagarde have reliable estimates of how much it takes to raise interest rates, the main policy tool, to achieve a given level of cooling.

To explain it, I keep thinking about the “excellent motor skills”hand-eye coordination that allows people to tie their shoelaces and button their shirts.

Well, both Powell and Lagarde are, in effect, trying to tie their shoelaces in the dark, while wearing gloves.

But here’s my question:

Why hasn’t it always been like this?

Running the Federal Reserve was never an easy job, of course, but it never seemed so tensewith a lot of risk of doing too little or too much.

Well, I have an answer:

The Federal Reserve’s job seemed easier because I wasn’t taking enough risks.

In particular, it has been conservative policies (in a non-political sense) that have kept the economy below its potential.

This slowdown in the economy meant they were there little risk of a strong inflationary attack, therefore little need for major political changes.

All the Fed had to do was gently curb if the economy seemed to approach potential or give the economy a little more gas if it started to falter; there wasn’t much drama involved.

But despite this conservatism gave Fed officials a relatively easy life, it came at a huge cost:

millions of job opportunities that we could have had, trillions of dollars of manufacturing that we could have produced.

It is true that the work of central banks is also becoming more difficult because there have been major shocks, the latest of which was a rise in commodity prices largely caused by Russia’s ongoing war in Ukraine.

But this isn’t the first time such a shock has occurred.

The the current shock is greatno doubt, but not much bigger than the shocks of 2008 and again 2010-2011, neither of which caused as much turmoil in central banks as they are experiencing now.

Note that there were no signs of an inflation peak between 2013 and 2019, although the unemployment rate eventually dropped below 4%.

This means that the Fed was constantly underestimating what the US economy was capable of achieving, even as its estimates gradually tracked down real unemployment.

And he acted on his mistaken belief:

from 2016 to 2019 the Federal Reserve rates gradually increased interest rate to avoid imaginary inflation risks.

The advantage of this conservatism for the Fed was that it isolated politicians from embarrassment.

Experience suggests that when the economy is weak, the Phillips curve is very flat or, to put it in something like English, the inflation rate it doesn’t depend much exactly how much play there is.

So there wasn’t much risk of deflation or painfully high inflation;

to the casual observer, it has always seemed that the Federal Reserve I knew what I was doing.

But running the economy below its potential came with huge hidden costs.

Suppose unemployment was 1 percentage point higher than it could have been.

This meant that the roughly 2 million Americans who might have been employed (the unemployed, plus those who would have joined the workforce had the job market been stronger) were not.

Since a point in the unemployment rate normally means approx 2 points of gross domestic product, we were losing about $400 billion a year in goods and services that we could have produced.

The good news is that both the Fed and the ECB are aware of their past sins and have entered the pandemic determined to be less conservative and to address more risks in the name of a strong economy.

The bad news is that his timing was unfortunate:

in fact, the risk of inflation has materialized.

But I’m willing to give them a lot of, uh, play.

If it never turns out that monetary policy has been too expansive, it means that it was always too severe.

And the Federal Reserve, I would say, is responding appropriately: Faced with the evidence that the economy is overheating, it is raising rates to cool the economy, and I, for example, am pretty sure we have peaked. of inflation. .

I am less optimistic about the ECB.

Long-term bond yields, which are what matters to the real economy, have risen in both Europe and the US, signaling that markets are expecting the ECB to tighten as much as the Fed.

However, if, as appears to be the case, European inflation reflects temporary shocks rather than an overheated economy, the ECB should not compete with the Fed.

So if the Fed is doing it right, the ECB is exaggerating.

On the other hand, Europe still has these things called trade unions, which have real bargaining power.

So maybe Lagarde fears a wage spiral and prices.

In any case, the point is that, in general, we want to see central banks face tough decisions.

Choices facing the Fed or the ECB may seem easier in an economy that is persistently a little depressed, but putting officials at ease is not a valid political goal.

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