The Fed Must Offset Fiscal Policy
Over at Bloomberg, Clive Crook suggests that monetary policy does not deserve all of the blame for the inflation overshoot:
The Fed’s fragile independence precludes it from challenging Congress and the administration over appropriate fiscal policy. For the same reason, it can’t be seen as directly countermanding fiscal policy with interest-rate changes, much as it might sometimes wish to. Tweak the monetary-policy framework by all means — but it isn’t the main problem.
In my view, the “same reason” suggests that the Fed must engage in “countermanding fiscal policy.” Indeed, Congress has given the Fed a mandate to countermand bad fiscal policy. They are breaking the law if they refuse to do so.
The Fed’s mandate includes stable prices, high employment and moderate long term interest rates. That’s the job that Congress has instructed the Fed to do. There is nothing in the Fed’s mandate about assisting fiscal policy. If the Fed believes that fiscal stimulus is likely to lead to a level of spending in excess of what is required for stable prices and high employment, then it must tighten monetary policy to offset the effects of the fiscal stimulus. When asked, numerous Fed officials have suggested that this is exactly how they approach their job.
If it really were true that Congress and the Fed worked together to produce stable prices and high employment, then the Fed would be well advised to challenge Congressional decisions on fiscal policy. Crook is right that it is not appropriate for the Fed to challenge Congress on fiscal policy—these are completely independent policymakers. And for exactly the same reason the Fed must do whatever it takes to achieve its Congressional mandate of stable prices and high employment, even if doing so requires a rise in interest rates during a period of fiscal stimulus.
I would also challenge the implicit assumption that the Congressional moves were primarily motivated by macroeconomic considerations. By 2021, the economy was recovering very rapidly from COVID, much faster than during 2009. The motivation for the large stimulus was mostly a mixture of three factors:
1. A desire to provide relief for people hurt by COVID.
2. The age-old desire of politicians to curry favor with the public.
3. The (incorrect) perception that interest rates would stay low for an extended period.
Notice that raising rates doesn’t prevent the stimulus from providing relief to the public; indeed the assistance goes a bit further if there is less inflation.
On the third point, keep in mind that an expansionary monetary policy tends to raise interest rates in the long run. I’ve been saying that for years, and lots of people refused to believe me. Now we see the effects.