U.S. Economic Report || The Fed’s Monetary Policy Exit Once Again Behind the Curve

The Fed’s Monetary Policy Exit Once Again Behind the Curve

Link to PDF: “The Fed’s Monetary Policy Exit Once Again Behind the Curve”

The linked paper “The Fed’s Monetary Policy Exit Once Again Behind the Curve” by Mickey D. Levy and Michael D. Bordo was presented to the Hoover Monetary Policy Conference at Stanford University May 6, 2022. Mr. Bordo is Economics Professor at Rutgers University and Morton Harris Distinguished Visiting Scholar at the Hoover Institution, Stanford University.

The Federal Reserve now finds itself in an uncomfortable situation that it failed to anticipate, but one that has occurred before in its modern history: it faces undesired high and rising inflation and is behind the curve, and must tighten monetary policy just enough to reduce inflation but not so much as to generate a recession.

This paper assesses the current situation through the lens of history, comparing the current inflation and the conduct of monetary policy to the recovery phase of prior business cycles. Focusing primarily on cycles since World War II, the paper highlights a persistent pattern of the Fed extending its monetary policy easing too long and delaying its tightening exits. Most frequently, this has led to rising inflation and then catch-up tightening that led to a recession more frequently than to a soft economic landing.

The paper finds many similarities between the current episode of inflation and the 1965-1982 period, but some important difference. Fiscal profligacy and monetary accommodation drove both inflation episodes, and the magnitude and pervasiveness of inflation is now mirroring the late 1960s and early 1970s (but not the late 1970s). In both the 1970s and 2021, the Fed blamed non-monetary causes and special factors for the high inflation. Fortunately, inflationary expectations and bond yields remain well below those in the 1970s, with important implications for stock valuations. Another big difference is the US dollar remains firm, in sharp contrast to its steep declines in the 1970s, that culminated in a currency crisis.

What factors have driven the Fed’s late exits? Evolving doctrines have encouraged more activist monetary policy and discretion that has led to mistakes. The Fed’s misreads of economic conditions and inflation also contributed to the bad timing of Fed exits. In addition, the Fed is under constant political pressure to maintain monetary accommodation and expand the scope of monetary policy to achieve the outcomes desired by the White House and Congress.

The paper states that the Fed’s delayed exit and surge in inflation is a wakeup call that strongly suggests the need for a monetary policy reset. It calls for the Fed to adopt more systematic rules-based guidelines in place of its discretionary approach and to correct the flaws in its new strategic plan, eliminating its asymmetries and establishing a balanced interpretation and approach to achieving its dual mandate.

Mickey Levy, mickey.levy@berenberg-us.com

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