The Werewolf Problem
Why the Fed needs to be Independent
Have you ever found yourself focused and determined to turn over a new leaf, to eat “clean,” to exercise daily, to lose 20 pounds and get fit? And so motivated, you stick with that self-pledge during the work-week, but, come Friday around 4 p.m., happy hour starts to beckon?
Your taste buds come alive at the thought of a cold beer or margarita. The anticipation of fried pickles titillates your senses. Just like that, the self-pledge is broken. Like a werewolf triggered by a full moon, the happy-hour alarm bell made you succumb to temptation. Your long-run goal quickly became subservient to the short-lived gratification of queso dip and daiquiris.
A Timing Disconnect
The problem with get-fit goals is they are not time-consistent. The benefits of the goal are long-term in nature. Yet, the pleasure of not sticking to that goal is immediate; and, the total cost of cheating on the goal only accrues over time. There is a disconnect in the timing with respect to the discipline it takes to stick with the goal, and the costs and benefits of the goal.1
Time-inconsistency is one reason it is so easy to deviate from the goal. If somehow your senses were as addicted to the feeling of “being disciplined” in pursuit of the goal in real time, then maybe you would not be so tempted to consume those french fries.2
Now imagine instead of get-fit plans, cold beer and chicken wings, you were in charge of Monetary Policy. Your goal now is to manage the macroeconomy.
Monetary Policy and Temptation
As part of the Federal Reserve’s strategy to manage the macroeconomy—as dictated by its dual mandate (explained by Macrosight here)—lowering rates is something the Fed does to either get us out of a recession or to deftly avoid a recession altogether (by lowering rates in a preemptive way as they have done the past two months).3
Why do they lower rates? Because it gives a boost to spending and helps the economy out overall.
Now, as the person in charge of monetary policy, YOU get to decide when to lower interest rates and how low they should go. And when I say “in charge” I do not mean that you are the Chair of the Board; rather pretend that you are the one and only Monetary Policy Czar. You have been elected by the People, and it is all up to you.
Like the get-fit goal described earlier, what would be your “time-consistency” temptation as the Czar? To answer that, let’s assume you know the following about macroeconomics:
You know that from a multitude of real-world historical evidence that high and volatile rates of inflation are bad for the long-run health of the macroeconomy.
You know that to keep inflation from getting out of hand, you should not push rates too low. And maybe you might need to raise them (just as the Fed did over eighteen months from 2022 to 2023, discussed in this post).
But, you also know that inflation typically “lags” spending, meaning that when spending increases in the economy it takes a while—months, perhaps a couple years—for the increase in demand to put pressure on prices to go up.4
That last little nugget of information is your temptation. By lowering rates, you can boost the economy. Yet, inflation is not likely to increase until much later. This feature of our business cycle is like having a cheat code to monetary policy, or so it seems at first. As the Czar, with the will of the People behind you, who could resist?!
Fed Independence
An important reason macroeconomists generally agree that central banks should be independent is due to the time-inconsistency (or temptation) issue related to carrying out monetary policy. There is an inherent temptation in setting monetary policy—“we can lower rates now, boost the economy, and worry about inflation later.” The problem with that seduction, however, is that once inflation has run amok it can be very costly to reign it in.5
What does it mean for the Fed to be “independent”? To paraphrase macroeconomist and former Federal Reserve Board Governor, Alan Blinder, that does not mean the Fed is independent in setting the goals for monetary policy.6 Rather, that is set by Congress, in the form of the Fed’s dual mandate. The Fed is obligated to carry out the mandate set forth by law.
What independence means for the Fed, or any central bank, is independence from political pressure or punishment. If members of Congress, the President, or even the public do not agree with the Fed’s decision, the Fed has protection from any pressure to reverse their decision or reprisal from those whom do not agree with the decision. Independence means the Fed has a firewall from political pressure.
The Werewolf Problem
Why should the Fed be insulated from political pressure? Because like the werewolf as the full moon rises, elected officials, frankly, cannot help themselves. Would you, as the elected Czar?
What if an election was coming up and you could lower rates to help out your own chances at re-election? Ah, the temptation!
What if, as the Czar, your approval ratings were low? Would you lower rates to pump the numbers back up? Like a plate of nacho-cheese fries sitting in front of you, how could you resist?
Well, if you were like the werewolf, you could not resist. That is why we do not have elected politicians running the Fed. That is why, as explained in last week’s post, the Fed is set-up to protect the decision makers from reprisal and retribution.
The time-inconsistency temptation related to maintaining low and stable inflation requires some sort of straight-jacket on the process, to keep those with their “fingers on the button” of money creation and interest rates from being seduced by the short-run benefits of lower rates at the expense of long-run macroeconomic pain.
The Board of Governors
So, why do we trust these individuals to do the job? The presumption is those folks and the members of the Federal Reserve understand their mandate and understand the implications of screwing it up. Given their backgrounds, that assumption is a reasonable one.
Does that imply they cannot screw it up or succumb to the time-inconsistency temptation? No it does not. Of course they can screw it up, as this blog has argued they did back in 2022 (here and here).
It is possible, too, they might act the werewolf and lower rates when they should not. What stops them? There are a number of features in place that holds the Fed and its members accountable. In addition, credibility matters. If the central bank—the Fed in our case—was to do such a thing, it would ruin its own credibility as an inflation-fighter. Going forward, why should anyone believe such a policy maker? In that case, inflation expectations would ratchet upwards and inflation itself would likely end up higher and more volatile for a long period of time. Speaking of which, this post is already long enough, so we will save discussion on accountability and credibility for a future post.
The benefits of being fit are also gained in the short-term. But in this scenario, if you are just starting out on your get-fit plan you will not see the benefits until later. Or, if you are already fit, the costs of back-sliding from your goal—via the weekly happy-hour or weekend indulgences—will accrue slowly, only becoming very apparent in the long-term.
Or tried some sort of commitment device, such as a drug that suppresses appetite or even a gastro-related surgery.
To be more precise with this example, I do not think the Fed has lowered the rates this fall out of an over-riding fear of an impending recession (their September forecasts to not suggest that, nor have their public comments). Instead, by lowering rates, the Fed is trying to “manage” the economy back to an interest rate they think is consistent with “stable inflation” and “stable employment.” That rate, whatever it may be exactly, is sometimes referred to as the “neutral rate.”
If you have ever taken a macroeconomics 101 class, your instructor would have referred to this phenomenon as “sticky prices.” Spending in the economy increases, but prices are slow to change. It takes a while for the spending pressure to “show up” in prices. For example, if you believe the explanation of Beastflation advocated by this blog, we saw this play out in 2020 through 2023. From mid-2020 through 2021 spending exploded. But, the price level (as measured by the consumer price index, for example), did not jump immediately in concert with that timing. Rather, inflation started to rise with a delay, picking up in mid-2021 and really ratcheting up in 2022 (as one can see in Figure 1 in this post).
Meaning you have to raise interest rates a lot, induce a recession, and cause people to lose their jobs. This is exactly what Paul Volcker faced as Fed Chairman in 1979, and what played out the next few years.
For anyone interested in the themes discussed in this post, or monetary policy in general, I highly recommend Alan Blinder’s book, “Central Banking in Theory and in Practice.” While the title might make it sound like a snooze-fest, Blinder explains the ins-and-outs of policy in a way that is friendly to the non-professional-economist reader. Not only are the explanations clear and concise, but the book is short, too. Blinder, an accomplished macroeconomist, served on the Board of Governors in the 1990s.