By Thomas Hogan
Issue 5: How to actually reduce inflation
Welcome to the final edition of Inflation Nation.
If you’ve been reading this newsletter every week for the past month, congratulations, you now know more about inflation than America’s central bankers.
Today, you get the issue you’ve been waiting for — the one with some solutions.
What would it take to get to a neutral monetary policy that supports exchange without creating inflation? We have a few ideas…
THE AIER COUNTER-INFLATIONARY TOOLBOX
Tool #1: Interest Rates
To start with, the Fed should do a better job with the tools it has. Fed officials created our current predicament by not raising interest rates soon enough. They continued their expansionary policies despite the signs of rising inflation. This whole situation could have been avoided if they had done their job and raised interest rates sooner.
Instead, they fumbled around for months without taking action. Powell kept saying price stability was job #1, but he kept on doing nothing about it.
The plan here is simple: When inflation comes in above target, raise interest rates.
💸 + 📈 = 👨👩👦
When you realize you’re too late, and you need to send a message, raise interest rates a lot! Don’t let inflation continue unabated. Don’t wait months and months to change policy when inflation has been overshooting your projections for half a year.
Tool #2: A Single, Specific Monetary Rule
The headlines — and the words of JPow himself — suggest that inflation is a huge mystery which demands constant Fed innovation.
But the general rules of economics do not, in fact, change year to year. In reality, monetary policy should follow one specific strategy or monetary rule and the Fed should clearly convey this strategy to the public.
They could start by faithfully adhering their own dual mandate. Or even adopting a monetary rule like a Taylor rule or a nominal growth rule that could combine the dual mandate into a single goal.
If the Fed is unwilling or unable to stick to their agreed-upon purpose, Congress should assign the Fed a single mandate or monetary rule (and then back out, since we don’t want Congress assigning it any new tasks).
“Making appropriate monetary policy in this uncertain environment requires a recognition that the economy often evolves in unexpected ways…Inflation has obviously surprised to the upside over the past year, and further surprises could be in store.”
-Jerome Powell
Tool 3: Monetary Neutrality
Like the role of government in general, there are basically two approaches the Fed can take: a light touch to do no harm or a heavy hand to do the most good. Most ivory tower economists think the Fed should guide the economy to prevent, or at least minimize, economic downturns.
But the Fed doesn’t exactly have a strong track record of predicting catastrophes. Even Fed economists, like former Chair Ben Barnanke, admit that the Fed caused the Great Depression of the 1930s and the Great Inflation of the 1960s and ‘70s. Fed officials tried to control the economy because they thought they knew best.
By contrast, adopting the goal of monetary neutrality — shooting for not too much money, and not too little — brought us the Great Moderation of the 1980s and ‘90s.
But in 2020, the Fed switched back to the heavy handed approach. As prices skyrocketed across the economy, they continued to push for “maximum employment.” That didn’t work out so well…
Part of the problem is that they were overconfident and relied too heavily on complex forecasting models, which had been consistently wrong for decades. They’ve tried manipulating the economy with activist monetary policy. It’s time to aim for a neutral policy and focus on the money supply.
Maintaining a stable monetary policy should be the Fed’s only concern. Not inequality. Not climate change. Not DEI.
Tool #4: Systematic Reform
Congress and Americans should think about big-picture reforms to the Fed. Some economists claim that the Fed did the best it could given its lack of information and lags in monetary policy. If that’s actually true, then we should design a better system. A few things that could help:
Return to the pre-2008 system of monetary policy. During the 2008 financial crisis, the Fed adopted a few “unconventional” monetary policies. You know, desperate times…desperate measures… But these policies — like Quantitative Easing and paying interest on bank reserves (often at above-market rates) — are not sustainable.
Shrink the Fed balance sheet. Since 2008, the Fed’s balance sheet has expanded from less than $1 trillion to almost $9 trillion. This has crowded out the short-term lending market by paying interest in bank reserves and it’s made the Fed the dominant force in the financial system. Let banks lend to each other, not just put all their reserves at the Fed.
Make emergency lending *only* for real emergencies. Covid was not a financial crisis. We need to prevent the Fed from creating new and unprecedented emergency lending facilities every time there’s an economic downturn.
Reform the FOMC. Monetary policy works in “long and variable lags” of about a year on average. Good monetary policy would require FOMC members to predict the future, which, as we have seen, they are not good at. They have been given an impossible task. We need a system that will create good policy despite the real-world knowledge and incentive problems.
Economists need to think about the best way for the Fed to make decisions given their real-world constraints. It’s time for reform.
Tool #5: Monetary Freedom
In any other industry, economists prefer competition to monopolies, least of all a monopoly run by the government. But for some reason they favor a central bank monopoly on the money supply. That’s weird.
The central bank system ensures that we only have access to one source of money. There is no way to hedge your bets. That means when the Fed makes mistakes, everyone in the whole economy is harmed.
Why don’t we just give people monetary freedom and let them decide? If they want to use gold, they can use gold. If they want to use cryptocurrency, use crypto. If they want to keep using dollars, hey, that’s fine too.
Even if we maintain a central bank, competition in currencies would discipline Fed policy and help reduce inflation. If people had alternatives, maybe Fed officials won’t be so irresponsible with the value of the dollar.
If we maintain a central bank, competition like this would discipline Fed policy and help reduce inflation.
Bitcoin vs. Gold
My colleagues David Waugh and Kate Waugh recently debated Bitcoin vs. Gold — and how each one might improve upon fiat currency — in an episode of AIER’s podcast Liberty Curious.
Tool #6: Self-destruct Button
In the end, we might even question: why do we need a central bank at all?
Some might say that money is a “public good” that needs to be provided by the government. But those arguments don’t hold water.
Money is not a public good. Whether a paper dollar or electronic bank deposits, money is a product. Like anything else, you buy it. We wouldn’t trust the government to make good basketballs, or cars, or computers. Why should we trust them to produce good money?
In fact, the market-based gold standard actually did pretty well relative to the Fed. Modern economic research proves so.
When asked in 1994 what he thought of the Federal Reserve, Milton Friedman said, “I’ve long been in favor of abolishing it. There’s no institution in the United States that has such a high public standing and such a poor record of performance.” – Milton Friedman on the Fed.
Well, our 5-week journey together is over, and that’s all we have for now. Thank you for taking a few minutes every week to dive into the important topic of inflation and arm yourself with the facts.
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