Jay Powell; policy Virtuoso or Charlatan?

Recent remarks by Jay Powell and by prominent economists reveal the fundamental problem with Federal Reserve monetary policy. Larry Summers and Paul Krugman agree that the Federal Reserve policy must be flexible in coming months, and that the Fed must not signal its intentions until the last possible moment. The situation in the economy is difficult and uncertain. The economy could be guided into a soft landing, or it could veer into a serious recession, depending upon the skill of the Federal Reserve board. Powell claims that the economy is in a unique situation. The COVID-19 shut down was a unique historical event; at no other time in modern history has a recession been caused by a global pandemic. In the coming months Powell will apply his talents to guide the economy back to the magic number of a 2% rate of inflation.

Milton Friedman and his student Robert Lucas proved that there is no systematic trade off between unemployment rates and inflation rates. Federal Reserve policy determines inflation rates. The strength of the effect of inflation on unemployment depends on the expectations of buyers and sellers of labor, on how people interpret and react to available economic data. In other words, people react strategically to monetary policy. Hence, there is no systematic tradeoff between inflation rates and unemployment rates. The inability of economists to define a reliable relationship between inflation and unemployment rates implies that monetary policy is arbitrary. Friedman reasoned that the Fed should target zero inflation, as a matter of economic science.

Economists generally agree that expectations matter, and that a reasonably well informed public can react to monetary policies in ways that nullify these policies. However, most economists still want the Federal Reserve to manage the economy. Most economists favor what we could charitably call the art of monetary policy.

We can't mathematically define a systematic trade off between inflation rates and unemployment. We supposedly can make up for the lack of a scientific relationship between inflation and unemployment by being clever and secretive. This is how former fed chair Alan Greenspan became known as the maestro of monetary policy. Greenspan became known for his cryptic remarks about Federal Reserve policies, and was seen to have skillfully guided us through a period of relative economic stability. Federal Reserve chair Ben Bernanke was thought to be the right man at the right time, an expert on the Great Depression who crafted Fed policy at the start of the Subprime crisis. Federal Reserve chair Janet Yellen was lauded as a little lady with a big IQ. Keep the public in the dark about monetary policy, and these clever people on the Federal Reserve board will manipulate the economy towards efficient ends.

Friedman and Lucas made valuable contributions to economics; they proved that the Federal Reserve couldn't manage the economy according to a set scientific formula. However, they left their intellectual opponents an opening, a path to destabilizing inflationary policies that most economists would find too appealing to ignore. The Federal Reserve board could supposedly assess any economic situation and adapt Fed policy to these conditions. Friedman's friend and colleague Friedrich Hayek warned against this supposedly artful but unscientific approach to Federal Reserve policy. Hayek argued that no central planner or board could understand prevailing economic conditions well enough to artfully manage any economy. Economies are complex beyond anyone’s comprehension. The belief, still popular among most economists, that we can “manage the economy” by outfoxing everyone in all markets with clever and secretive policies is sheer vanity.

Correct understanding of Federal Reserve policy requires an understanding of both Milton Friedman and Friedrich Hayek. Economists generally understand Friedman, but have overlooked Hayek’s insights regarding central bank policies. The problem with attempts by the Federal Reserve to manage the economy isn't just that trade-offs between inflation and unemployment are temporary and somewhat unpredictable. Efforts by the Federal Reserve to stimulate the economy with inflation during the 1970s inevitably backfired and raised unemployment rates to high levels. Will the coming recession be as bad as what we endured during the early 1980s? Maybe not. However, we can learn from our recent experiences. The recent remarks made by Powell, Summers, and Krugman are tacit admissions that Friedman and Hayek are right about current policy. We should further recognize that all attempts to manage any economy with inflation are unscientific and arbitrary. The Federal Reserve Board is always flying blind. Economic science does tell us what the best rate of inflation is, and that rate is always zero. The sooner Jerome Powell learns this fundamental truth, the better for all of us.