Five myths about the Federal Reserve

Stevenson is an associate professor of public policy and economics at the University of Michigan.

The Federal Reserve lowered the benchmark interest rate this past week by a quarter-point to just under 2.25%, the first rate cut since December 2008. President Donald Trump had been hectoring the bank to do this for months, as had many Wall Street analysts. But stock markets had a mixed reaction to the news, and it remains unclear whether more cuts are ahead. For many Americans, the Fed’s role in the economy is shrouded in myths. Here are some of the most prevalent.

Myth No. 1: The White House cannot influence monetary policy.

While Trump repeatedly called on the Fed to lower interest rates, Chairman Jerome Powell stood up to the pressure, stating unequivocally that the Fed would make its own independent decision about whether and by how much to change rates, and that he would not resign even if Trump asked him to. The conventional wisdom is that the president "can't do much about the Fed," as Bloomberg News put it in April.

It's true that neither the president nor Congress can command Powell to lower rates. And it's true that the Fed is protected to an extent from politics because, since it answers to Congress, Trump cannot easily fire Powell. (Although Trump has asked his lawyers to look into ways to do it.) However, the president picks the chairman and the other governors of the Federal Reserve, and the Senate confirms them. Powell, Trump's choice for chairman, has a strong record of judicious monetary-policy decision-making. But Trump's more recent nominees have been less aligned with mainstream monetary-policy experts; they do not have much monetary-policy experience and are more clearly Trump loyalists. If the Senate confirms them, the president will gain more sway over monetary policy, albeit indirectly through the decisions made by his appointees.

There's another subtle way Congress and the White House influence the Fed: If they don't like what the Fed is doing, they can pass legislation giving themselves more control over monetary policy. Many lawmakers would like to give Congress more power over interest rate decisions, and the Fed operates in the shadow of this possibility.

Myth No. 2: The Fed isn't audited.

Sen. Rand Paul, R-Ky., has repeatedly introduced legislation, known as "Audit the Fed," to exert greater control over the central bank. Other lawmakers have picked up this theme. Sen. John Kennedy, R-La., wrote an op-ed for the Hill in 2017 headlined, "American taxpayers deserve an audit of the Federal Reserve." It's great marketing, because it's created the myth that the Fed isn't audited.

But the Fed's financial activities, balance sheets, programs and operations are all heavily audited. The Government Accountability Office (GAO) polices the Fed's finances and activities, such as loans it makes to individual financial institutions. The Fed's own inspector general hires an outside auditor to review financial statements, compliance with laws and regulations, programs, and operations. These audits are made public for all to review.

What Paul's legislation would actually do is require audits of the Fed's monetary-policy decisions, rather than just its balance sheets and operations. That would essentially give Congress the ability to change monetary policy by making the GAO into a shadow Fed that could help legislators overrule the Fed's decisions. This idea makes economists nervous because reducing the Fed's independence over monetary policy would likely lead to higher inflation, on average.

Myth No. 3: Low interest rates are always good for the economy.

In January, Trump tweeted, "Can you imagine if I had long term ZERO interest rates to play with like the past administration, rather than the rapidly raised normalized rates we have today." It's clear that he thinks lower rates made things easier for his predecessor and would make things easier for him. Borrowers do like lower interest rates, as Trump apparently does, but cheap money isn't always in the country's long-run best interest.

Consider the role of interest rates in the economy: They determine the price of spending today vs. spending tomorrow. When rates are low, it costs less to borrow, and you are rewarded less for saving. So low rates encourage spending today. That means lower rates can push gross domestic product temporarily higher by stimulating lots of immediate spending.

But that may not be sustainable. When people and businesses want to spend more than we've produced - and if the economy is already producing as much as it can with the equipment and workers it has - it pushes up prices. So if the Fed lowers rates so much that it stimulates too much spending, inflation will result. And higher inflation will persist long after the temporary blip in GDP dissipates. Politicians often think too much about the short run and ignore long-term damage, but the Fed's job is to stay focused on the goals of keeping employment high and stable, and inflation low and stable, today and into the future.

Myth No. 4: We would be better off with no inflation.

Everyone loves to hear about falling prices and low inflation. Congress periodically tries to pass legislation to tell the Fed to aim for no inflation at all, as then-Sen. Connie Mack, R-Fla., and then-Rep. James Saxton, R-N.J., did in the mid-1990s with the Economic Growth and Price Stability Act, which Republican leaders signed onto. Consumers like low inflation, because it means prices stay low and their income goes further.

But there's are several reasons the Fed has a goal of 2% inflation. First, an inflation rate slightly above zero avoids accidental deflation of the economy. The reality is that the Fed can't precisely hit its inflation rate target. In fact, the Fed has often found that inflation falls below its goal of 2%. If the Fed targeted zero percent and inflation dropped below that, we'd have deflation. And that can wreak havoc on the economy: Falling prices lead people to postpone purchases, thinking things will get even cheaper, which slows the economy down.

The second problem with a zero percent inflation target is that the Fed would be more likely to face what's known as the zero lower bound. If the economy begins to slow, the Fed's response is to reduce nominal interest rates. But aiming for no inflation would drive rates lower to begin with, leaving less room for the Fed to maneuver before they got to zero.

A third reason is that a little bit of inflation - say, below 4 percent - helps grease the wheels of the economy. Employers often find it difficult to cut wages directly, even when needed to save jobs. So they use inflation to adjust the real value of wages. (If your raise isn't keeping up with inflation, your wages won't buy as much as they did the year before. It's the same thing as a pay cut, even though the numbers on your check don't change.)That may sound bad, but it lets companies keep more people employed during a downturn than they otherwise could.

Finally, many economists believe that inflation is actually lower than the measured rate that the Fed uses because of measurement challenges like adjusting for technological advances, new products and the ways shopping patterns change when relative prices change.

Myth No. 5: Inflation has become unrelated to unemployment.

Low unemployment and higher inflation have long been correlated - a relationship known as the Phillips curve. But the correlation appears to have broken down over the past decade, as inflation has hovered around 2 percent both during the high unemployment of the Great Recession and through a long expansion that has delivered record-low unemployment. This has led economists and journalists to speculate that the Phillips curve is dead. Trump's economic adviser Larry Kudlow and Rep. Alexandria Ocasio-Cortez, D-N.Y., recently found common ground on this issue, with Kudlow praising the congresswoman's grilling of Powell about the apparent demise of the Phillips curve.

But the relationship between unemployment and inflation is not dead - it's just hard to see. When we look at the data, we are not seeing how inflation and unemployment move in response to market forces; instead, we are seeing the Fed actively trying to keep inflation near its 2% target. So the relationship between inflation and unemployment now reflects the Fed either undershooting or overshooting its target rate. By succeeding at keeping inflation near its target, the Fed effectively made it impossible to see the Phillips curve in the data.

But the labor market can still spur inflation. If the market gets really tight - meaning workers are hard to find - employers raise wages. That can be great, if it means companies give a greater share of their profits to workers. But if employers pass on some of their higher wage costs to customers, prices will rise, sparking inflation. The “death” of the Phillips curve doesn’t change what the Fed should do. Rather, it is a result of what the Fed has already done.

Originally published by The Washington Post

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