Sleepwalkers

Are we about to make some very costly, potentially avoidable errors? Or have I simply failed to learn from recent experience? You be the judge.

You know, I would love to be able to say that I had gotten all my calls right about inflation over the past year or two. That would have been nice, because it’s no fun being wrong, and because then I might more credibly argue that it might be time for the Fed to take a break here. Unfortunately, I didn’t get all those calls right. Egg on my face. But it still needs to be said: maybe the Fed really ought to consider taking a break here.

The situation we’re in now is obviously not all the Fed’s doing. We had a pandemic, we have a war, we’ve had decades of compounding bad decisions and weakening trust within and across countries. It’s obviously not Jerome Powell’s fault that Xi Jinping has taken China in a disastrous direction, or that Vladimir Putin has invaded Russia, or that Britain is now governed by Liz Truss. And it is easy to understand why the Fed has chosen the course that it has chosen over the past nine months. Its job is to deliver low and stable inflation, and it has limited tools with which to achieve that aim. What else can it do under present circumstances than use those limited tools to try to deliver on that aim?

But look: we need to be clear-eyed about the state of the world. Adam Tooze likes to characterize world events as taking place within an unfolding polycrisis: which is to say, the world is experiencing multiple disruptive shocks which interact in ways that tend to foil our efforts to try to solve our problems. It is a word that can easily be overused to exaggerate the seriousness of what are actually quite run-of-the-mill difficulties. There is no question that it applies now. 

After the past three very difficult years, the social fabric is stretched to the point of tearing across much of the world. We experience, on just about a weekly basis, extreme weather events which leave our economies and our societies less resilient in the face of other problems. We have one nuclear-armed superpower which is losing a war and which is potentially facing a domestic political crisis. We have another nuclear-armed superpower in which the authoritarian leader is negotiating his way through a tricky effort to secure his absolute power, in the face of a domestic economic crisis and an increasingly tense relationship with yet another nuclear-armed superpower. The world economy is sinking toward recession, squeezed by high food and energy prices and the most intense round of synchronous monetary tightening in at least 40 years. There is no give in the system. Maybe no final straw will come to rest on the camel’s back. But we have not been particularly lucky of late.

In this context, robust American economic growth ought to be something to cheer. American demand can bolster economies elsewhere. And of course, America faces its own serious domestic political crisis, which might just about be kept in check for the moment if a strong economy boosts the electoral fortunes of the party that still believes in democracy. But from a global perspective this robust American growth is a curse, because it means that the Fed will carry on with its work, tightening the monetary screws until it snuffs out America’s expansion—or until something important breaks. 

I don’t know what exactly will break. There are many, many weak points across the global economy, and the markets’ staggering on news that Britain’s new budget has £10bn more in borrowing than previously announced suggests that it need not be something obvious or even particularly big that pushes the world over the edge. But problems that seem manageable right now will very quickly come to look impossible if big things begin to go wrong: if some small but important economy unexpectedly faces balance-of-payments troubles, maybe, which gets a bank or two in a bind, which prompts a chaotic scramble for dollars, triggering hasty and ill-advised market interventions, which lead to cascading economic difficulties and people in the streets and who knows what else. It doesn’t have to go like that. There are lots of ways it could go, which is precisely the problem.

Under these circumstances, there is no avoiding the fact that the dollar is the world’s reserve currency, that Treasury bonds are the world’s most critical safe asset, and that the stance of American monetary policy has massive effects on financial conditions worldwide. Jerome Powell and the rest of the Federal Open Market Committee can close their eyes and stick their fingers in their ears and mutter that the Fed is an American institution charged with managing the American economy with no obligations to the rest of the world la-la la-la la-la. In the end, that will not absolve them in history’s eyes if the financial strain induced by American rate hikes help push the world into disaster.

There is a very boring and mandate-oriented way to try to make the point. The Fed’s actions have global spillovers; this is well documented in the economic literature. Those spillovers can have effects which wash back over the American economy, in destabilizing ways. If the Fed does not take adequate account of those spillovers, then it runs the risk of making a policy error as judged against its own narrow domestic mandates. Given the very large uncertainty facing the Fed right now, it seems prudent to pause tightening for a moment, so as not to carelessly stumble into a global economic state that is considerably less consistent with maximum employment and stable prices than what we’ve got now.

The broader point is that now is a moment for caution and good judgment. I understand why Fed officials are doing what they’re doing. They are central bankers who feel they have betrayed the one core principle of the central banker. They feel that they risk destroying the dearly-purchased legacy of Paul Volcker. 

But what did Paul Volcker do? Did he dumbly repeat the actions of some past central-bank hero, hoping to achieve good results by luck? No, although dumbly following through on one orthodoxy or another has historically been a common cause of central-banking disasters. Rather, Volcker took a risk, and broke new ground. Sometimes you have to do that. Sometimes the situation demands it.

In truth, I’m not certain that the benefits of Volcker’s actions were worth the costs. Yes, inflation came down. But in addition to the severe recession he caused in the United States, high American interest rates and a soaring dollar did terrible damage to economies around the world, especially developing ones. We know that this happened. And this is the experience which the Fed now seems determined to imitate, at this moment, in this state of the world. 

Would pausing present risks? Yes, of course. Larry Summers and others have been warning the Fed not to relent prematurely, saying that that is precisely the error central bankers made in the 1970s and initially in the 1980s. Blink now, and inflation may rise and become more persistent, such that even harsher policy is needed to finally get things under control down the road. And it is true, things could go that way. But maybe down the road is a much better time, all things considered, for harsh medicine. Maybe inflation will stay in the high single digits and that won’t, in the end, mean the end of the world. Maybe the global economic weakness that is already baked into the cake will in fact be enough to bring price pressures to heel. We shouldn’t feel confident about any of that, but we should be clear-eyed about what benefits we expect to get from current Fed policy and whether they do in fact make the potential costs of that policy worth bearing.

Others will say that a dovish pivot in Fed policy will be dangerous in and of itself, will be destabilizing, will cause a loss of confidence in the dollar, and so on. And sure, that is something which could conceivably happen. But let’s try to be sensible about this. Was the policy stance that markets perceived the Fed to have back in mid-summer, before Powell made clear that several more 75 basis-point hikes would be coming, dangerously risky? One could certainly argue that it was inconsistent with a rapid reduction in inflation back to target, I’ll grant that. But did it threaten to make the near-term situation drastically worse? No, it didn’t. A pause now would mean a looser policy position relative to that mid-summer stance, but not by much. But equally, a pause does not mean abandoning the fight against inflation; it merely preserves an optionality that will be lost if big things begin breaking. 

And, if Americans are unhappy with a Fed pause, there are other things which can be done to address the inflation problem. Congress has shown that it can legislate. It can legislate up a temporary tax that will directly address spending within the American economy, so that the Fed doesn’t need to achieve its domestic policy goals by inducing ever tighter financial conditions across a world economy that may be unable to bear them. This challenge is important enough and this moment is dangerous enough that we should be willing to entertain some outside-the-box ideas. You don’t want the Fed to change course? Fine, at least grapple with the dangers of the moment and throw out some other ideas about how to defuse them.

Because blindly following a monetary orthodoxy in a fragile world leads to very bad places. And it is really beyond time that we have a serious conversation about the potential global cost of keeping Fed policy on its current path. Of course, a Fed policy shift won’t magically solve everything. Things could still go very wrong in many different ways; that’s what it is to be in the midst of a polycrisis! And of course, there is a chance that things will somehow work out fine even if the Fed continues on. But it seems to me that monetary policy is following a course that may look very puzzling to future historians, as they look at what we stood to gain from a quick return to low inflation, and what we ended up losing.

But as I said at the outset, my track record on this inflation isn’t what I would like it to be, so do with this what you will…