The fed is inept – price controls on inflation fail and only make the crisis worse

Mr. Cochrane believes that “we overstate the Fed’s power” to respond: “The Fed likes to say it has ‘the tools’ to contain inflation, but never dares to say just what those tools are.” In recent historical experience, “its tool is to replay 1980,” the year when inflation peaked at 14.8%. That means “20% interest rates, a bruising recession that hurts the disadvantaged, with the medicine applied for as long as it takes. Will our Fed really do that? Will our Congress let our Fed do that?”

In any case, Mr. Cochrane says, raising rates is a “crude tool to fight inflation, especially when the source is fiscal policy.” He likens the situation to a car going too fast. “Fiscal policy is the accelerator; monetary policy controls the oil. OK, if fiscal policy has floored it, you can slow the car down by draining oil, but that’s not a terribly good way to drive.” Fiscal policy sends checks, stoking inflation; monetary policy raises interest rates to discourage borrowing or encourage savers to hold the extra Treasury debt. To change the analogy slightly, the driver is accelerating and braking at the same time.

To overcome inflation, fiscal constraints on monetary policy will need to play a large role, Mr. Cochrane says: “The Fed is merely a copilot.” He notes that in 1980, the ratio of debt to gross domestic product was 25%. Today it is 100% and rising: “Fiscal constraints on monetary policy are four times larger today.” So for a rise in interest rates to lower inflation, “fiscal policy must tighten as well. Without that fiscal cooperation, monetary policy cannot lower inflation.”

An additional complication is that any increase in interest rates raises interest costs of servicing the debt. “The government must pay those higher interest costs by raising tax revenues and cutting spending, or by credibly promising to do so in the future.” At 100% debt to GDP, he says, “5% higher interest rates mean an additional deficit of 5% of GDP, or $1 trillion, for every year that high interest rates continue.” This consideration is especially relevant if fiscal policy is at the root of the inflation.

“If we’re having an inflation because people don’t believe the government can pay off the deficits it’s running to send people checks, and it will not reform the looming larger entitlement promises, then people won’t believe the government can pay off the additional $1 trillion deficit to pay off interest costs.” Result: “The central bank raises rates to fight inflation, which raises the deficit via interest costs, which only makes inflation worse.”

What kind of policy path would it take to stabilize inflation? Mr. Cochrane relies on history as well as theory. “Inflations do not happen to happily growing economies, whose governments run things well and with flush treasuries.” Historically, inflations have always come “to countries in trouble, primarily fiscal trouble, but fiscal trouble caused by bad macroeconomic policies.”

When people fundamentally distrust the government to repay debt, interest-rate policies and quantitative easing have limited power. So “the bottom line” is to ensure that people have faith in the government as debtor, and that comes “from solid growth, and transparent, responsible, durable institutions.” There’s no way out without “regulatory reform, tax reform, entitlement reform, as well as clear-eyed monetary policy that works on the narrow things it actually understands.”

Mr. Cochrane wants Americans to grasp that ending inflation “isn’t just technocrats at the Federal Reserve fiddling with interest rates.” Healthy economies don’t have inflation “no matter what the central banks do,” while dysfunctional ones have inflation even with “heroic central bank presidents.”