The Fed’s bond purchases make matters worse by enabling Washington’s fiscal irresponsibility.
The Federal Reserve’s monetary policy is broken. Normalization of interest rates has been needed for years to allow markets, not regulators, to allocate capital. But with interest rates at 5.5% and the dollar strong, the inflation battle must shift to the problem of government spending and regulation. The Fed’s silence on the fiscal and regulatory roots of this inflation crisis, and its insistence on using an antiquated inflation model that blames growth and jobs for price hikes, risks an even weaker U.S. economy.
America’s two immediate inflation risks are rising fuel prices and wage costs, both of which are attributable to government. Constrictive regulations on natural gas, nuclear energy, pipelines and electrical grid maintenance have limited energy supplies unnecessarily. Unprecedented entitlement spending held down the labor-force participation rate, as labor disruptions and regulations to increase the power of union organizers added labor costs without increasing productivity or helping workers.
Neither problem will be helped by another rate hike. Energy production is capital-intensive and sensitive to interest rates, while Washington’s inflationary spending is indifferent to rising rates, given the government’s unlimited borrowing power.
Far from easing economic distress, the Fed’s plan to raise interest rates if inflation persists would hurt the economy as a whole. Headlines applaud the economy’s resilience, but at 2.1% growth it’s weak by historical standards and projected to stay that way. Gross domestic product is being propped up by record government spending that counts toward GDP now but provides little support for future growth and adds to the national debt. The economy is filled with danger spots. Many parts of the private sector are completing projects that were funded before the rate hikes but aren’t planning new investments because of high interest rates and weak growth expectations.
This augurs years of slow, government-dominated growth. We need much faster growth to break out of our economic funk, lift median income, meet the geopolitical and technology challenge from China, pay for defense and debt service, lower the national debt, and take good care of an aging society.
But the central bank has become part of the growth problem—in part because of policy changes after the 2008-09 financial crisis. Today’s Fed is silent on, or even enables, inflationary fiscal policies. After 2008 the central bank began paying interest on trillions of dollars borrowed from banks and money-market funds—it will pay more than $23 billion in September alone. The Fed bought huge tranches of government bonds as if it were a hedge fund, exposing taxpayers to massive losses when rates eventually came back up. The bond buying heavily subsidized Washington and other elite bond issuers but contributed directly to the global wave of inequality and excess government debt. At the same time, the Fed greatly intensified its regulatory control over bank lending, pushing banks away from the short-term working capital lending needed for robust growth.
In essence, the central bank is picking winners and losers. The New York Federal Reserve Bank’s April Open Market Operations report describes a plan to buy trillions more in government bonds, further entwining fiscal and monetary policy, concentrating capital, and channeling it to one of the biggest winners—government.
Present policy envisions high short-term interest rates, permanent central-bank ownership of bonds, and silence on the dollar and fiscal policy. We need the opposite. Rather than setting rates even higher—or, worse, changing the inflation target from 2% to 3%—the Fed should create a path to rate cuts through policies that provide price stability and faster supply growth. This would curb inflation through an economic expansion rather than a contraction.
There are three key steps. First, organize a U.S. government commitment to a strong and stable dollar. There was an explicit Group of 20 consensus on currency stability from 2017-20 that the U.S. could easily renew. A robust policy-based defense of the dollar is critical to growth, price stability, and competition with China.
Second, allow dynamic business investment. This is vital to stopping the shift in global power toward Russia and China. The Fed is the world’s biggest bank regulator and user of short-term liquidity to hold bonds. Shrinking its balance sheet and improving capital-adequacy regulation would dramatically improve the economy’s supply side.
Third, help improve fiscal policies. The central bank has influence as one of the government’s largest fiscal partners. It can’t stay silent on government spending, the latest failure to rewrite the debt ceiling, or the Fitch downgrade. As it holds its tongue, the Fed’s dual mandates for price stability and full employment are slipping away.
Because businesses work with an eye to the future, the Fed could elicit immediate improvement in growth and inflation expectations if it clearly communicates new policies that would lead to rate cuts, a stable dollar and smaller central bank bond holdings. If the Fed really wants to fight inflation and break out of the 2% growth funk, that’s the way to do it.
Mr. Malpass served as president of the World Bank, 2019-23, and undersecretary of the U.S. Treasury, 2017-19.
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Appeared in the September 12, 2023, print edition as ‘Government Policies, Not Low Rates, Are Driving Inflation’.