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The Fed’s Monumental Change on How It Views Stimulus and Inflation

Yuval Rosenberg
·3 min read

The hot economic debate of the moment is over the size of President Joe Biden’s pandemic relief plan and fears, raised by economists Larry Summers and Olivier Blanchard, that it might be so large as to cause the economy to overheat and result in surging inflation.

Over at New York magazine’s Intelligencer, Eric Levitz puts that debate into some important historical context. In doing so, he also lays out the significance of recent policy shifts by the Federal Reserve and of Fed Chair Jerome Powell’s speech this week in which he said that the real unemployment rate is significantly higher than the official 6.3% and is probably closer to 10% once the millions of people who have been driven out of the labor market by the pandemic, as well as those who have been misclassified as being employed by the Bureau of Labor Statistics, are factored into the calculation. “Despite the surprising speed of recovery early on, we are still very far from a strong labor market whose benefits are broadly shared,” Powell said, adding that fully repairing the job market “will take continued support from both near-term policy and longer-run investments.”

Powell was effectively intervening in the ongoing economic debate on Biden’s behalf, Levitz writes, explaining that the Fed chief’s comments represent a monumental change:

“In the late 1970s, stubbornly high inflation taught the central bank that the conflict between its dual objectives — to promote full employment and price stability — was fiercer than it had previously thought. Specifically, the Fed decided that it would need to preemptively cool the economy when unemployment got too low, so as to snuff out inflationary spirals before they took hold. This was because tight labor markets allowed workers to hold their employers hostage to unreasonable wage demands; with no reserve army of the unemployed to draw new hires from, bosses were forced to placate existing staff. Thus, employers ended up overpaying their workers and then trying to compensate by overcharging consumers. ... Therefore, central banks had to proactively preserve slack in the labor market — both by slowing economic growth through interest-rate hikes when unemployment got too low, and by encouraging Congress to rein in deficit spending lest it spur excessive demand for labor.

“Under Jerome Powell, the central bank has brought American monetary policy into belated alignment with federal law and empirical economics. Instead of attempting to preempt high inflation by sustaining a cushion of unemployment, Powell has waited for inflation to actually show itself before deliberately cooling the economy, a posture he has justified by emphasizing the myriad economic and social benefits of maximizing employment.”

Powell’s speech signaled support for further fiscal stimulus and a belief that the economy can bear lower levels of unemployment without a worrisome rise in inflation. “Perhaps most significantly,” Levitz says, “Powell broke with past Fed chairman Ben Bernanke by arguing that fiscal and monetary stimulus doesn’t just accelerate an economy’s return to full productive capacity, but rather, that stimulus can actually grow the economy’s long-term growth potential.”

The bottom line: Powell has been making an emphatic case for more fiscal support for the economy and job market, and that argument represents a dramatic shift with potentially significant implications for the politics of federal spending. Unsurprisingly, the Biden White House is embracing the Fed chair’s view. “Based on the reporting I've done,” The Washington Post’s Jeff Stein tweeted this week, “I think it's safe to say Jerome Powell's comments hold vastly more sway over the White House economic team than Larry Summer's.”

Read the full piece at New York.

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