Thursday, December 1 2022

The author is an FT Contributing Editor

Every Federal Reserve press conference follows the same pattern – growing and stagnant, low and high inflation. Journalists ask when the Fed will be convinced that its tools are working. The poor Fed Chairman doesn’t really have an answer and says the central bank is watching carefully, reminding the media that monetary policy has a “long and variable lag” or words to that effect.

It was the format this week when Chairman Jay Powell spoke to the press after another 0.75 percentage point rate hike as the Fed waits for inflation to come down. But it could just as well have been Janet Yellen or Ben Bernanke. This exquisite expression “long and variable lag” is a technical way of saying “we don’t know and we don’t know when we will”.

Monetary policymakers have been saying this for so long that we have allowed them to turn it into a kind of privilege. They don’t have to adapt. They don’t need to be creative. Their tools must not work. Central bankers are forever behind. It doesn’t work now – but it could.

The phrase itself derives from one of the founding documents of today’s central banking regime, Milton Friedman of 1959 A Monetary stability program. Friedman pointed out that the Fed could use its balance sheet to raise or lower the total money supply in the economy, but peaks in inflation tended to follow peaks in money supply with a “considerable lag” that was also “rather variable”. . This is a monetarist argument, which has fallen out of favor among macroeconomists. But the language remained blocked.

In this same book, Friedman offered a comprehensive list of central banking tools. The Fed could supervise or regulate the banks. It could pursue a specific credit policy, encouraging or discouraging different types of loans. Or it could encourage or discourage credit in general, particularly by buying and selling securities on the open market.

Friedman was not the only twentieth century influence on monetary policy. But it’s hard to overstate its power to define what was and wasn’t good central bank work. In his Programhe swept supervision and specific credit policy off the table, and said that open market operations were Monetary Policy.

Ben Bernanke won his Nobel Prize this year for his landmark work on how bank meltdowns lead to economic meltdowns, as the remaining healthy banks struggle to determine who gets the credit. It is indeed a happy coincidence that he served as Fed Chairman during the financial crisis, working with Congress and the White House to find creative ways to keep banks from collapsing.

But Bernanke also served as president for several years after the crisis. He wrote the plans for how the Fed would think and react, not just in a crisis, but as part of its normal work. When the Fed did its policy review in 2019 and 2020, it really didn’t change anything. It is Jay Powell who addresses the press, but it is still Ben Bernanke’s Fed today.

Bernanke accelerated the pace at which the Fed released its internal projections, saying it was bad to surprise the markets and that in fact it could be useful to guide them more regularly and more clearly on what was coming. Like other central bankers, he adopted an inflation target. But Bernanke, who as a graduate student had studied Friedman’s monetary history closely, also stayed within the boundaries that Friedman had drawn so clearly in 1959. Regulation and specific credit remained irrelevant in as monetary policy tools. The Fed’s only tool was the Liberty Street office in New York where it bought and sold Treasury bills and federal agency securities on the open market.

The problem now is not that Friedman and Bernanke got it wrong. You can be right for a while, then when things change, you do something different. But there doesn’t seem to be any urgency at the Fed on the tools. For years the Fed has failed to meet its inflation target and, well, there is a lag. These things happen. Now, using the same framework, it’s unclear whether the Fed is bringing inflation back to its target, leaving Powell behind the podium talking about recent research on lags.

Even Bernanke himself, in his most recent work, 21st century monetary policy, concludes by examining the tools that other central banks have tried – buying stocks and corporate bonds, offering funding for specific types of bank loans. He even briefly mentions the purchase of bank loans, as the Fed has done during the pandemic. But he doesn’t see the Fed pressuring Congress for regular use of these tools anytime soon, or Congress granting them.

The Fed is pulling up and down on a lever that may not be attached to anything, hoping it gets lucky. Who knows? It could. The lags are long and variable.


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