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Is the Fed Playing Politics With Interest Rates?

Is the Fed Playing Politics With Interest Rates?

When the U.S. Federal Reserve decides where to set interest rates, it’s supposed to set aside political considerations and focus solely on what’s best for the economy. I’m starting to wonder, though, whether the Fed is starting to stray from this model of independence — and I’m worried about what that might mean for inflation.

At their most recent policy-making meeting, Fed officials decided to keep short-term interest rates near zero, and gave no indication that they’re planning to raise rates significantly (or at all) over the next six to 12 months. This commitment to easy money must be seen as somewhat surprising, given that inflation is running well above the central bank’s long-term target of 2%. As of September, the price index for personal consumption expenditures was up 4.4% from a year earlier, the fastest rate of growth in 30 years. Even if one removes volatile food and energy prices, the PCE inflation rate exceeds 3.5%, still the highest in 30 years. These data suggest at least a nontrivial risk of a return to the persistent inflationary psychology that the U.S. experienced during the 1970s, and that required a brutal period of extremely tight monetary policy to tame.

I agree with the Fed’s analysis that the high inflation rate stems largely from supply bottlenecks. If a chip shortage is preventing the production of enough cars to satisfy demand, prices will naturally rise. But this doesn’t mean that the Fed is powerless to curb price increases. Economists typically think of inflation as the result of excess demand — that is, demand minus supply. The Fed can’t influence supply, as Chair Jerome Powell emphasized this week. But it can lower demand, and hence excess demand, by raising interest rates. If, for example, rates on auto loans were higher, the reduced demand for the existing supply of cars would relieve some of the pressure on prices.

Why, then, is the Fed so reluctant to act? One possibility is that it’s willing to tolerate high inflation to achieve its other mandate of ensuring that people who want jobs can readily get them. But with the unemployment rate at 4.8%, close to a historical low, this argument seems less than compelling. Also, the Job Openings and Labor Turnover Survey indicates that jobs are much more plentiful than willing and able workers.

So if the issue isn’t employment, then what? Another possible explanation is politics. The Biden administration has yet to signal whether it plans to appoint Chair Powell to a second term when his current one runs out in February. If Powell wants reappointment, it might behoove him to curry favor with the administration and its left-wing critics by keeping monetary policy loose. I certainly hope this isn’t the case: Whether conscious or not, it would represent the same kind of monetary-policy politicization that many economists believe gave rise to the runaway inflation of the 1970s. That’s an experience nobody should want to repeat.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Narayana Kocherlakota is a Bloomberg Opinion columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.

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