Can Central Banks Maintain Their Autonomy?

Over the last three decades, the Fed and its counterparts have enjoyed wide latitude in trying to control inflation. Recent failures could soon put that independence to the test.

By Nick Timiraos of The WSJ. Excerpts:

"High inflation “is a significant institutional failure,” said John Cochrane, a senior fellow at the Hoover Institution, addressing a panel of current and former Fed officials in May. “Maybe it was nobody’s fault, but when you target 2% and it’s 8%—if this is an army, you have an after-action report. There’s a court-martial. You figure out what went wrong.”

So what did go wrong? Any postmortem has to begin with the freak nature of the pandemic itself, in which governments and societies across the world—not always at the same time—drastically curtailed economic activity as new waves of the virus spread. During the most aggressive lockdowns in 2020, governments quickly scaled up wage-replacement schemes to prevent severe distress. Supply chains were thrown into chaos.

“A simple way to think about what’s happened is the pandemic was like a war, and you had war financing—lots of spending, not just in the U.S. but around the world,” said St. Louis Fed President James Bullard. Fiscal and monetary policy makers decided “if we were going to err, we were going to err on the side of doing too much,” he said.

Policy makers wanted to avoid what they saw as the same mistakes they had made in the years after the 2008 financial crisis, when they had pushed for belt-tightening despite sluggish economic growth. In hindsight, this led to four new mistakes in responding to the pandemic’s effects.

First, the Fed misdiagnosed the labor market in 2021 as weaker than it was because officials didn’t realize how much it had changed during the pandemic. The unemployment rate ultimately returned to the low levels seen before Covid-19 hit the U.S. economy in March 2020, but with a key difference: around 2.5 million fewer workers. This has led to widespread labor shortages and wage increases, creating upward pressure on inflation.

Second, central bankers’ models were based on the last 20 years of inflation experience, when the main risks to growth came from weak demand from consumers and businesses for goods and services. They didn’t imagine that as the nation recovered from the pandemic, demand would come back much more strongly than the economy’s ability to supply goods and services. Shortages of items such as microchips, motor vehicles and bicycles erupted, driving up prices.

In the U.S., those two mistakes contributed to a third: The Fed didn’t immediately adjust its policies after President Biden’s $1.9 trillion stimulus was enacted in March 2021. The stimulus was much larger than had been forecast, pumping up consumer demand."

"Finally, the pandemic struck just as U.S. and European central bankers were concluding reviews of the policy frameworks they had used to address the problems bedeviling their economies since the 2008 crisis. They wanted to avoid a rut of slow growth and low inflation that would cripple their ability to stimulate the economy in a downturn. They had seen Japan struggle to escape that trap for most of the previous two decades, even after cutting interest rates to zero or below."

"Last November, Mr. Powell and his colleagues began admitting that the Fed had underestimated how much the pandemic had constrained both the economy’s labor supply and its ability to provide goods and services."

"For the last 30 years, “Central banks had the wind at their backs,” said Kenneth Rogoff, an economist at Harvard University. “Globalization, productivity gains from China, demographics, and maybe the political zeitgeist of the time favoring higher growth—all helped them deliver low inflation.”"