Yet another Federal Reserve governor has come out in support of the plans to taper off the central bank’s asset purchase program. This time it is Randal Quarles, who was appointed to the Federal Reserve Board by President Trump. He has a slightly more conservative profile than other board members, but the fact that he speaks up after Governors Waller and Bowman is a significant signal to the Biden administration: it is not the conservative wing of the Federal Open Market Committee that is driving the central bank’s commitment to tapering asset purchases. That commitment stands on universal support throughout the Fed’s leadership.
With such widespread backing of an asset-purchase drawdown across the Fed leadership, it will be difficult for the president to replace Jerome Powell and fill vacant FOMC seats with monetary radicals. This is good of course, for two reasons, the first being that the Fed is asserting its institutional – and thereby policy – independence. One of the reasons why it has stood so firm as the leading central bank in the world for so long is that it has maintained a political independence that is admired, even envied around the world.
The second reason is that the leadership of the Federal Reserve are genuinely worried about where inflation is heading. Some people have wanted them to put up a harder fight for monetary conservatism, tapering their asset purchases earlier than is now (very likely) going to be the case. However, it is easy to forget that the Fed actually has two main policy goals: price stability and full employment. This is not the case with, e.g., the European Central Bank, whose only explicit policy goal is to keep inflation down, come Hell or High Water. In reality, the ECB has abandoned its sole-goal focus and spent the past decade essentially propping up fiscally failing welfare states, but from a strict statutory viewpoint, the ECB should be more conservative in its monetary policy than the Federal Reserve.
It may seem like an insoluble conflict for a central bank to promote both full employment and price stability, but the fact of the matter is that ever since we got out of the stagflation episode almost 40 years ago, it has been relatively easy for the Fed to accommodate both its policy goals. The main reason is not that the Fed has had a particularly intelligent leadership – it has, of course, but since the Reagan tax reform, Congress has made the Fed’s job relatively easy. Despite chronic budget deficits (except for four years under President Clinton) the central bank remained solidly independent, even in its policy practice, from the Treasury and from Congress.
Though not formalized until Ben Bernanke replaced Alan Greenspan at the helm of the Fed, the practice of monetizing budget deficits first saw the light of day after the 9/11 attacks when the Bush Jr. administration wanted to reassure the American people, their businesses and their economy that normalcy would prevail. Greenspan agreed to a temporary monetary stimulus without dedicated focus on deficit monetization, but the precedent had nevertheless been set: the Fed would virtually eliminate interest rates in order to secure full employment.
It was this precedent that Bernanke stood on when he formalized Quantitative Easing, a.k.a., the monetization of budget deficits. By helping Congress to spend without worry about the cost of deficits, the Fed again prioritized full employment over price stability. However, despite objections aplenty from orthodox monetarists of rampant inflation to come, we never saw a conflict between the Fed’s two policy goals.
There are many reasons why deficit monetization did not spark inflation until 2021. They are all centered around the so-called transmission mechanisms that send monetary expansion into the real sector of the economy; this is not the time to examine them in detail, but I would like to point out that they are centered around the welfare state and its entitlement program. This is important to keep in mind as we listen to what Governor Quarles has to say in defense of the Fed’s asset-purchase tapering, which he defended yesterday while speaking at the Milken Institute Global Conference “Charting a New Course”. Quarles did, namely, bring up the policy-goal conflict from an angle we have not seen taken by the Federal Reserve since the stagflation era four decades ago. It was with this conflict in mind that he made a strong case for a less expansionary monetary policy:
Recent data suggest that growth in the third quarter is likely to be lower than we had expected, but the foundations remain in place for strong economic growth over the remainder of this year and next. Employment is growing, financial conditions are accommodative, businesses are investing, and households, in the aggregate, have a large stock of savings to draw on for future spending.
This is a rosier picture of the economy than it deserves, but Quarles has a reason to make it a bit rosy. First, though, he acknowledges that not all numbers come in as desired:
Weaker growth in payrolls in August and September, along with uneven consumer spending in July and August, appear to reflect ongoing concerns in some parts of the country about the spread of COVID-19, especially in high-contact service industries. Supply bottlenecks and labor shortages that have been more widespread and persistent than many expected are camouflaging continued strong underlying demand for goods, services, and workers.
Then he makes a very interesting little point that is essential for his case against monetary stimulus:
Supply constraints are particularly evident in interest-sensitive parts of the economy, such as residential investment and vehicle sales, limiting the scope for additional monetary accommodation to stimulate activity in those sectors.
In other words, you can give people whatever zero-interest loans you want in order to finance a new car, but if the dealer’s lot is empty that zero-interest loan, and the money printing that helped it come about, will have made no difference in the economy.
Quarles goes on to explain that whatever rocky patches he sees in the economy today, are only temporary. They have, he says, “for the most part simply postponed activity temporarily”. He mentions some national-accounts data supporting this outlook, data that I will be reporting on separately. Overall, Quarles explains,
there is ample evidence that the demand for labor is strong. At last measure, the Labor Department reported that job openings remained near a record high in August, and a record number of workers were voluntarily quitting their jobs, an indicator of their confidence in finding a better one.
I would not be so quick to draw that conclusion. A sizable portion of the workforce – particularly in its younger segment – became accustomed last year to live reasonably well without having to work. Until all our benefits programs are back to pre-Covid shutdown levels, I would add to Quarles’s point that government is actually giving people a reason to voluntarily quit their jobs. In other words, his indicator of a strong economy is not necessarily an indicator of a strong economy.
He has his reasons, though, for giving it more emphasis than it deserves:
Since the middle of last year, the Fed has been increasing its holdings of Treasury securities and agency mortgage-backed securities by $120 billion a month to foster smooth market functioning and to support the economy by putting downward pressure on interest rates. Conditions had improved considerably by the time we announced our forward guidance for asset purchases in December, but the unemployment rate remained at 6.7 percent … and inflation was running significantly below 2 percent. As we sit here today, demand for labor is strong, and unemployment has declined to 4.8 percent. … Inflation … is running at more than twice the FOMC’s longer-run goal.
This is as clearly as Quarles can say “we are getting really worried about inflation”. Therefore, he explains:
Taking all of the evidence into account, I think it is clear that we have met the test of substantial further progress toward both our employment and our inflation mandates, and I would support a decision at our November meeting to start reducing these purchases and complete that process by the middle of next year.
Then he throws in a noteworthy comment:
Reducing purchases and ending them on this schedule is not monetary tightening, but a gradual reduction in the pace at which we are adding accommodation.
Plain and simple: Quarles knows that the debate from hereon until Jerome Powell is (hopefully) confirmed inevitably will be about differences in monetary policy regimes. He knows that President Biden is under serious pressure from monetary radicals on the left flank of the Democrat party to put expansionists on the FOMC. This is Quarles’s way of claiming his stake in that debate.
It is also his way of telling the opposition to Powell’s reappointment to drop the ancillary criticism they have. Recently, there have been allegations about portfolio-management improprieties against leading Federal Reserve officials, a criticism that has been angled as a reason for Biden to replace Powell. The extent of these improprieties has never been firmly established, and the generalized nature of them suggests that there is more smoke than fire behind the criticism.
That said, for someone like Governor Quarles it becomes important to counter that criticism and bring the debate over Powell’s reappointment – which underlies his entire speech – back to where it belongs: monetary policy.
To that point, Quarles explains:
[We] are facing a situation now where inflation is high even though employment has yet to fully recover from the COVID event. In that case, according to the FOMC’s monetary policy framework, when objectives are not complementary, the Committee “takes into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.”
Bluntly speaking: right now it is more urgent to fight inflation than to stimulate aggregate demand in the economy.
Then he drills right down to the core of his argument:
Applying those principles throughout 2021, we have been very patient and focused on the need for the labor market to recover as quickly as practicable from the severe damage experienced during the darkest days of the COVID event. We are remaining patient because, despite some periods of rapid progress, the recovery in jobs has been uneven and is still incomplete. Early on, patience was easy: In December of last year, my FOMC colleagues and I were expecting much lower inflation—the median projection for 2021 by FOMC participants was 1.8 percent. The FOMC’s preferred inflation gauge did not crack 2 percent until March 2021. But, by June, prices had risen 4 percent over the previous 12 months, ticked up to 4.2 percent in July, and increased further to 4.3 percent in August. The median of the most recent projections by FOMC participants traces a path in which inflation ends the year just a touch lower than the current level.
I have to point out that at the time the FOMC was predicting 1.8 percent inflation for 2021, I was predicting 9.5-10 percent. Since then, reality has pulled the FOMC in my direction. Nevertheless, Quarles’s point here is that inflation has overtaken unemployment as the Fed’s most urgent policy focus. If Federal Reserve Governors Quarles, Waller, Bowman and – presumably – Chairman Jerome Powell have it their way, the central bank will spend at least the next year fighting inflation at the explicit expense of unemployment.
Such a priority will, of course, upset the radicals in the Democrat party. The FOMC will not care too much about that; the question is what President Biden will do with the up to four seats on the FOMC that he will probably be filling in the coming year.