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In the second week of December, the Federal Reserve Open Market Committee (FOMC) met for the first time since Chairman Jerome Powell conceded that ongoing inflation is unlikely to be transitory. The meeting's inconsistent conclusions are unlikely to inspire confidence.
There is a distinct possibility the Federal Reserve is about to hit a wall, and that its very constitutional underpinnings will soon come into question.
To understand why, we must zoom out and look at the bigger picture. The Fed prides itself on its independence from political scrutiny. More than any other federal entity, the Fed claims for itself an absolute independence in its capacity to set U.S. monetary policy. This autonomy rests on the assumption that the economists running the institution have "scientific" or "objective" criteria for setting policy. In essence, they argue that setting monetary policy is akin to solving an engineering problem—say, calculating how wide the arches on a bridge should be.
This supposed objectivity itself depends on a theory known as the "equilibrium rate of interest"—known in the economic literature as the R*. The R* is the rate of interest at which the rate of employment is maximized, and the rate of inflation is stable. The R* is to central banks what the crown is to the King—it gives them their authority and their credibility. If the R* is an illusion, then central banks do not have the capacity to "objectively" set the rate of interest.
The theory and the data behind the R* have always been dubious, even if academic critiques have thus far had no success in overturning the theory. Developments taking place in the economy today, however, may finally threaten its regal hegemony.
After the FOMC met in mid-December, its members signaled to the markets that they would not raise interest rates aggressively to counter the spiraling inflation currently taking place. They made the case for this decision by projecting that inflation would fall from its currently high levels in 2022. Why will it fall? We were not told. Indeed, the notion that inflation will fall seems to imply that it is transitory—contrary to what Fed Chairman Jerome Powell said just two weeks before the FOMC meeting.
The reality is that the Fed is between a rock and a hard place. For the past decade, it has maintained extremely low interest rates to try to generate economic growth. These low rates have given rise to manias in multiple markets—from stock markets to bond markets to housing markets. The Fed economists know that if they slam their foot on the brakes, these markets will fall—hard. On the other hand, if they do not raise rates and inflation continues to spiral, they will be blamed for the chaos. By pursuing their policy of choice for the past 40 years—which in practice has meant ever lower interest rates—they have painted themselves into a corner.
This explains the inconsistency. Jerome Powell is talking out of two sides of his mouth because he cannot do otherwise. There is no easy option, no obviously correct choice.
This brings us back to the hallowed R*. According to the R* theory there is always an obviously correct choice. After all, monetary policy is just an engineering problem, right? And the Fed economists are brain boxes that we trust to solve this giant engineering problem, right? Well, no, it would seem not.
It is hard to come to any other conclusion: if the high inflation continues—which seems more likely than not—the R* theoretical framework is going to collapse. Consider the Fed projections of the interest rate. They are signaling that the interest rate will be no higher than 1 percent in 2022 and no higher than 2.5 percent in the foreseeable future.
This means that the "real interest rate"—that is, the interest rate after inflation—will be between minus 4.5 percent and minus 6 percent if inflation continues at its present rate. If inflation continues to accelerate, it will be lower still. The R* theory always focuses on the real interest rate, but the projection that this equilibrium interest rate should be deeply negative—especially with unemployment so low—is prima facie absurd. No sane economist could possibly make the case that an R* in a developed, functional economy with high rates of employment should be so deeply negative.
That leaves the economists in a bind. If November-Jerome Powell is correct and inflation is not transitory, then the theoretical basis on which the Fed rests its claims to independence is cooked. The FOMC therefore must hope and pray that December-Jerome Powell is correct, and that inflation will die down of its own accord in 2022. I believe that American football fans refer to this sort of strategy as a Hail-Mary pass.
As the theoretical basis for monetary policy hollows itself out, expect the public to be livid. Not only will prices rise as pay checks fail to keep pace, but people's savings will be obliterated. If someone wants to keep some or all of her savings in a simple bank savings account, her wealth will be eroding at a pace of anywhere between 4.5 percent and 6 percent annually. The average Joe will not need to understand the nuances of the R* theory to realize that this situation is absurd.
The Fed's credibility now rests on a punt and a prayer. If this inflation does not turn out to be transitory, the Fed is going to lose credibility at every level. I am not offering a salve or a solution. I am not sure what they should do. All I know is that if I were offered a seat on the FOMC tomorrow I would probably pass.
Philip Pilkington is a macroeconomist with nearly a decade of experience working in investment markets, he is the author of the book The Reformation in Economics: A Deconstruction and Reconstruction of Economic Theory.
The views expressed in this article are the writer's own.
