The Fed & inflation; misunderstanding or miscalculation?

The Federal Reserve Bank failed at its most important job, it allowed inflation to rise. Why? Do Federal Reserve officials lack a theoretical understanding of economics? Did Federal Reserve officials miscalculate in applying economic theory to the formation of monetary policy?

Fed Chair Powell remarked yesterday that economic growth was below trend last year, but inflation is now, and is projected to remain, too high. Chair Powell has advanced a curious set of propositions. Theoretically speaking, below trend economic growth causes deflation, not inflation. In reality, we have below trend growth and inflation most of the time. Two possibilities emerge when theory and data diverge. First, the theory might be wrong. Second, there might be measurement error in the data.

We estimate trend economic activity with potential GDP. The people who estimate potential GDP revised this figure downwards after the 2008 crisis. Why was this done? The financial crisis was followed by high unemployment and low capacity utilization in industry. However, a financial crisis doesn't necessarily harm labor skills, the labor force, technology, total capacity, or any other real factor in the economy. Downward revision of potential GDP in 2008 was empirically correct, and part of the reason for this was expected long term crowding out of private investment by federal borrowing.

Problems with real resources caused the economic slowdown in 2022. Average life expectancy in the US has fallen, and the working age population has stopped growing. There are several reasons for falling life expectancy; fentanyl overdoses, rising suicide rates, COVID-19 fatalities, and perhaps bad dietary habits. Some people have dropped out of the labor force. Post COVID syndrome prevented some people from working. The CARES act paid people to stay out of work; this delayed the return of 3.4 million workers to employment. Recent demographic changes in the US were large enough to warrant changes in estimates of potential GDP. There have also been shifts in labor force participation. Yet, no changes in potential GDP estimates have been made.

This is not a mere technical issue. The Federal Reserve plans policy according to differences between what is produced and what can be produced. Our fundamental theoretical understanding of inflation is correct. Inflation derives from too much money chasing too few goods. Real losses in labor supply means we can produce fewer goods relative to the money supply. The Fed Chair sets policy according to official numbers on the economy. Powell likely underestimated the potential for inflation, thought it would be transitory, partly because he overestimated potential GDP.

We must keep in mind that there is always a “recognition lag” in adapting policies to shifts in the economy. It takes time to collect and assess data on shifts in the economy. This means we not only lack precise theoretical models of how to balance inflation with unemployment, we also lack accurate recent data on all shifts in the economy.

Powell's mistake was in believing that he possessed the knowledge one would need to use transitory inflation to stimulate the economy. Powell bears direct responsibility for our current economic situation. However, ultimate responsibility for the current economic situation lies with those politicians and citizens who demanded “stimulus” policies from the Fed that were in fact the source of current instability.