The Fed Faces a New World
By Matthew C. Klein
Central bankers have no popular mandate. They are not elected and are only indirectly accountable to the public. Yet they are granted the “independence” to take unpopular decisions, at least up to a point. Their independence isn't guaranteed, nor does it always mean the same thing at different points in time. Rather, it is contingent on circumstances.
As Philipp Carlsson-Szlezak and Paul Swartz of Bernstein Research put it in a recent note, “Central banks cannot escape their political underpinnings.”
In the years after the financial crisis, the political environment probably constrained the Federal Reserve’s ability to boost the U.S. economy. Things may now be shifting in the other direction.
Consider Fed Chairman Jerome Powell’s latest experience testifying before Congress, which occurred this past week. On Tuesday and Wednesday, he took questions from the Senate and the House, respectively. While many of the questions focused on technical issues, such as the implementation of the new Current Expected Credit Loss accounting standard, the optimal level of bank reserves held on deposit at the Fed, and the Fed’s process for vetting proposed bank mergers, several members from both parties pushed Powell and his colleagues to focus on raising wages and altering the economic split between workers and investors.
Sen. Sherrod Brown (D., Ohio) told Powell that he believed “the Fed has the authority and the duty to be creative, to help workers share in the prosperity they create.” Sen. Tom Cotton (R., Ark.) wanted to know why “we’re seeing more income going into the hands of owners in this country and less into the hands of workers.” He then went on to clarify that he wanted “more of that economic pie going into the hands of our workers.”
Rep. Denny Heck (D., Wash.) wanted to know whether Powell and his colleagues would be “willing to let wage growth climb to 4% to begin to recover some of the decline that we’ve experienced in the labor share of income.” Heck also declared that “we need to place a greater emphasis on wage growth.” Rep. Roger William (R., Texas) warned Powell to “be careful when you start raising the interest rates because it can affect the economy.”
These are only a few legislators, but they could be a harbinger of a shift compared with the recent past. It wasn't long ago that prominent politicians criticized Ben Bernanke for “printing money” and Janet Yellen for keeping interest rates too low. That external pressure could help explain why the Fed has been more willing to err on the side of undershooting its inflation objective by limiting the size of its asset-purchase programs and raising interest rates in response to strong employment data. Its efforts to boost the economy always came with caveats about upcoming exit plans.
The Fed’s hawkish critics have been replaced by a bipartisan coalition in favor of faster wage growth and a cautious approach to monetary tightening, with President Donald Trump the most obvious member.
The new perspective would be a return to normal. For most of the Fed’s history, U.S. politicians have preferred to push the central bank to lower interest rates to boost growth even if that would theoretically risk excess inflation. The first, and most extreme, example was in the 1930s, when President Franklin D. Roosevelt restructured the Fed’s governance and operations in response to the failure of the Depression. Reflation was the priority, which eventually included an explicit promise to cap interest rates during and after World War II.
The Fed temporarily regained some of its autonomy—and an anti-inflationary mind-set—in the 1950s, but by the mid-1960s it was once again being pressured by politicians to focus more on growth. President Lyndon Johnson accosted Fed Chairman William McChesney Martin and claimed that interest-rate increases were an affront to the men fighting in Vietnam. While Martin did raise rates after that meeting, his efforts were not nearly sufficient to arrest America’s inflationary trend.
President Richard Nixon successfully pressured Arthur Burns—with the help of Alan Greenspan, Burns’ former Ph.D. student—to boost the economy in advance of the 1972 election. Paul Volcker’s disinflationary campaign faced relentless attacks from across the political spectrum during his tenure. He eventually felt compelled to leave the Fed after it became stacked with officials he disagreed with.
Greenspan, who had gotten the Fed job in 1987 in part because of his reputation as a loyal political hack, soon found himself facing severe criticism for his perceived unwillingness to respond to the recession of the early 1990s. (Unlike his predecessors, Greenspan had the political smarts to cultivate allies in Congress and the business community.) By the mid-1990s, however, he was self-censoring.
Even though he believed it would ultimately hurt the economy, Greenspan felt the Fed lacked the political capital to lean against the stock market bubble. Despite being at the peak of his prestige, he therefore chose to do nothing. “Independence” was only worth so much.
The changing political environment could cause a shift in Powell’s stated priorities. He has repeatedly claimed that wage growth should equal inflation plus productivity growth, but not exceed it. That, however, is a recipe for keeping the labor share of income constant. It would not reverse the decline since 2000. The only way to raise workers’ pay relative to the value of what they produce is for wages to grow by more than inflation plus productivity.
Paul McCulley, then Pimco’s chief economist, made this point in 2014, citing his colleague Richard Clarida and dubbing the labor share of income “Rich’s Ratio.” After years in which workers bore the brunt of the Fed’s “war” on inflation, McCulley judged that the time had come for a “peace dividend.” Shortly thereafter, Clarida argued that real wages could rise faster than productivity without risking inflation because the growth would manifest in a higher labor share of income. Clarida, of course, is now the Fed’s vice chairman.
Consider Fed Chairman Jerome Powell’s latest experience testifying before Congress, which occurred this past week. On Tuesday and Wednesday, he took questions from the Senate and the House, respectively. While many of the questions focused on technical issues, such as the implementation of the new Current Expected Credit Loss accounting standard, the optimal level of bank reserves held on deposit at the Fed, and the Fed’s process for vetting proposed bank mergers, several members from both parties pushed Powell and his colleagues to focus on raising wages and altering the economic split between workers and investors.
Sen. Sherrod Brown (D., Ohio) told Powell that he believed “the Fed has the authority and the duty to be creative, to help workers share in the prosperity they create.” Sen. Tom Cotton (R., Ark.) wanted to know why “we’re seeing more income going into the hands of owners in this country and less into the hands of workers.” He then went on to clarify that he wanted “more of that economic pie going into the hands of our workers.”
Rep. Denny Heck (D., Wash.) wanted to know whether Powell and his colleagues would be “willing to let wage growth climb to 4% to begin to recover some of the decline that we’ve experienced in the labor share of income.” Heck also declared that “we need to place a greater emphasis on wage growth.” Rep. Roger William (R., Texas) warned Powell to “be careful when you start raising the interest rates because it can affect the economy.”
These are only a few legislators, but they could be a harbinger of a shift compared with the recent past. It wasn't long ago that prominent politicians criticized Ben Bernanke for “printing money” and Janet Yellen for keeping interest rates too low. That external pressure could help explain why the Fed has been more willing to err on the side of undershooting its inflation objective by limiting the size of its asset-purchase programs and raising interest rates in response to strong employment data. Its efforts to boost the economy always came with caveats about upcoming exit plans.
The Fed’s hawkish critics have been replaced by a bipartisan coalition in favor of faster wage growth and a cautious approach to monetary tightening, with President Donald Trump the most obvious member.
The new perspective would be a return to normal. For most of the Fed’s history, U.S. politicians have preferred to push the central bank to lower interest rates to boost growth even if that would theoretically risk excess inflation. The first, and most extreme, example was in the 1930s, when President Franklin D. Roosevelt restructured the Fed’s governance and operations in response to the failure of the Depression. Reflation was the priority, which eventually included an explicit promise to cap interest rates during and after World War II.
The Fed temporarily regained some of its autonomy—and an anti-inflationary mind-set—in the 1950s, but by the mid-1960s it was once again being pressured by politicians to focus more on growth. President Lyndon Johnson accosted Fed Chairman William McChesney Martin and claimed that interest-rate increases were an affront to the men fighting in Vietnam. While Martin did raise rates after that meeting, his efforts were not nearly sufficient to arrest America’s inflationary trend.
President Richard Nixon successfully pressured Arthur Burns—with the help of Alan Greenspan, Burns’ former Ph.D. student—to boost the economy in advance of the 1972 election. Paul Volcker’s disinflationary campaign faced relentless attacks from across the political spectrum during his tenure. He eventually felt compelled to leave the Fed after it became stacked with officials he disagreed with.
Greenspan, who had gotten the Fed job in 1987 in part because of his reputation as a loyal political hack, soon found himself facing severe criticism for his perceived unwillingness to respond to the recession of the early 1990s. (Unlike his predecessors, Greenspan had the political smarts to cultivate allies in Congress and the business community.) By the mid-1990s, however, he was self-censoring.
Even though he believed it would ultimately hurt the economy, Greenspan felt the Fed lacked the political capital to lean against the stock market bubble. Despite being at the peak of his prestige, he therefore chose to do nothing. “Independence” was only worth so much.
The changing political environment could cause a shift in Powell’s stated priorities. He has repeatedly claimed that wage growth should equal inflation plus productivity growth, but not exceed it. That, however, is a recipe for keeping the labor share of income constant. It would not reverse the decline since 2000. The only way to raise workers’ pay relative to the value of what they produce is for wages to grow by more than inflation plus productivity.
Paul McCulley, then Pimco’s chief economist, made this point in 2014, citing his colleague Richard Clarida and dubbing the labor share of income “Rich’s Ratio.” After years in which workers bore the brunt of the Fed’s “war” on inflation, McCulley judged that the time had come for a “peace dividend.” Shortly thereafter, Clarida argued that real wages could rise faster than productivity without risking inflation because the growth would manifest in a higher labor share of income. Clarida, of course, is now the Fed’s vice chairman.
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