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    United States Socialist Republic book by HG Goerner

    Inflation Nation, Issue 2: How does the Fed cause inflation?

    By Thomas Hogan, Ph.D.

    In the first issue of Inflation Nation, we went over a few of the government’s favorite inflation bogeymen: Putin, the supply chain, and higher wages.

    As you (now) know, none of these factors is influential enough to be the scapegoat the White House is looking for. Allow me to introduce you to the real culprit — the Fed.

    Q: Where did the Fed come from?

    The Federal Reserve System was founded by Congress in 1913 in response to the financial panics of 1893 and 1907 (which they wrongly blamed on the gold standard). As the United States’ central bank, the Fed prints paper money, sets interest rates, and regulates U.S. banks.

    Q: What is the Fed’s “Dual Mandate”?
    When you hear people talking about the Fed’s “Dual Mandate,” they’re referring to something in the Federal Reserve Reform Act of 1977, in which Congress updated the 1913 act and gave the Fed a list of specific goals: “To promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

    These are noble goals, at least when the Fed is free to pursue responsible monetary policy rather than political objectives. Economic research shows that monetary policy works best when conducted by an independent central bank, after all.

    This mandate is also where that magic 2% inflation goal comes from. The Federal Open Market Committee (FOMC) determined that a goal of 2% inflation was the ideal rate to help foster maximum employment and price stability.

    Q: Are the Fed’s economic projections reliable?
    For starters, the goals the Fed was set up to achieve are fundamentally unachievable. The Fed can’t predict the future; no one can. Because monetary policy works in what Milton Friedman called “long and variable lags,” the Fed is being asked to do the impossible by enacting monetary policy today that might not affect the economy for a year or more.

    Since the entire project is starting from a false founding principle, you won’t be surprised to learn that the Fed’s economic projections are not reliable.

    As I explained in an article I published in Public Choice about bias in the Fed, GDP forecasts by the Federal Open Market Committee (FOMC) between 1992 and 2016 were very inaccurate, especially in the years during and after the Great Recession.

    Q: Is the Fed politically neutral?

    Unfortunately, Fed chairs in the 1960s and ‘70s caved to pressure from American Presidents. And though those who followed largely sought to reestablish the Fed’s independence, since 2019, the Fed has politicized its activities in virtually every way: through monetary policy goals, the use of the enhanced balance sheet, regulatory actions, and emergency lending activities.

    In August of 2020, for example, the Fed rewrote its mandate to emphasize employment ahead of inflation, citing racial differences in unemployment rates as a motivation for the change. Their pandemic emergency loans were not to support the financial system, but were bailouts for non-financial companies and municipal governments. Bank regulation is more concerned with climate change than financial stability.

    Each of these changes has pushed the Fed further from being an effective and independent central bank toward becoming a purely political institution, which prevents it from choosing the best policies for Americans and the U.S. economy.

    Q: Is the Fed good at its job?
    How has the Fed performed? Has it fostered “stability, integrity, and efficiency” like its mission statement demands? Is the U.S. monetary system operating at “optimal economic performance”

    Not exactly.

    The Fed is supposed to ensure stability in times of great uncertainty, but its track record is brutal.

    The Fed was supposed to prevent bank failures, but it was actually the main cause of the Great Depression. Since then, it has led to higher inflation, lower economic growth, and more economic volatility across the board than we had during the gold standard.

    The Fed’s forecast errors, which I mentioned above, were at their worst around the time of the Great Recession in 2008. In September of 2008, the Fed’s GDP growth forecast showed 90% confidence that we would avoid a recession… According to data from the National Bureau of Economic Research, the recession officially began in December of 2007. The economy had been in recession for 10 months, and the Fed staff was still predicting there would be no recession!

    Fed Chair Jerome Powell recently said “we now understand how little we understand about inflation.” He also said “So really, everyone had the same model — which was the Phillips curve model.” That obviously turned out to be very wrong.

    Finally, let’s look at how the Fed causes inflation using 2021-2022 as a case study.

    The Federal Reserve Guide to Causing Record Inflation

    Step 1: Misunderstand inflation by relying too heavily on complex (but wrong) mathematical models.

    Step 2: Repeatedly underestimate inflation. Despite obvious trends, the Fed just kept revising their projections upward, month after month.

    Step 3: Even once you realize inflation is way too high, refuse to act. The FOMC repeatedly raised its inflation projections but refused to end its overly expansive monetary policy.

    Step 4: See the harm you’re causing the average American, but decide to look the other way and focus on inequality and climate change.

    Step 5: Finally raise interest rates, but do it by too little and way, way, way too late.

    And that, folks, is how you create record inflation.

    Join me next week to dive into what that means for you and the American economy, beyond expensive gas and chicken.

    Until next week,

    Thomas Hogan, Ph.D.

    Senior Research Faculty, AIER



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