Kevin Warsh will have a difficult task ahead. But it is not quite the one most political and economic analysts have been emphasizing. For much of the commentariat, Warsh’s problem is that he needs to hike interest rates, and defy Trump. Many are concerned that he won't have the courage to do it.
Although he was seen as a hawk on inflation, he has been tempted by the possibility that artificial intelligence might raise productivity and allow lower interest rates. Like Alan Greenspan in the 1990s, who came to believe that the internet had reduced the inflationary impact of growth, Warsh appears, at least circumstantially, as a dove. Worse, he might do Trump's bidding and effectively end the independence of the Fed (gasps from the audience), and undermine its credibility (a terror flick for very serious economists).
But for most commentators the mild acceleration of inflation, associated to the price of oil and the war in Iran, and the uncertainty about the actual impact of AI (on that see Austan Goolsbee on Soumaya Keynes podcast) have made that position look less tenable for most analysts. Hence the renewed calls not merely to resist Trump’s pressure for lower rates, but to hike them. To imitate Powell, in this view, would be the path to respectability. Perhaps even to glory. It would also be a mistake.
Ruchir Sharma, for example, draws the conventional hard-money conclusion. Warsh, he argues, should begin his tenure by raising rates and ending the Fed’s easy-money bias. The argument is wrapped in populist language. Inflation hurts workers and the poor, while easy money fuels asset prices and benefits the rich. There is a kernel of truth there. But it is not always the case (see also). Besides rate hikes will not produce cheaper oil. The best hope there is the end of the war in Iran.
Powell was lucky. His interest-rate hikes did not produce a recession through the housing channel, reducing credit and consumption. But those hikes were not the main reason inflation came down. Inflation declined largely because the cost-push pressures associated with the pandemic value-chain disruptions and the oil shock after the Ukraine war subsided. The lesson is not that Powell became Volcker and saved the Republic. The lesson is that supply shocks eventually faded, and the Fed received more credit than it deserved.
This is the problem with the constant invocation of Volcker. As I argued before in my post on Paul Volcker’s legacy, the conventional story exaggerates the virtues of monetary toughness and obscures the social costs of disinflation. The Volcker shock was not a technocratic morality play in which courage defeated inflation. It was a brutal tightening that produced a deep recession, weakened labor, and accelerated the decline of workers bargaining power. It also caused the debt crisis and the lost decade for several developing countries. To recommend that Warsh seek his Volcker moment is to misunderstand both the causes of the current inflation and the political economy of monetary policy.
The same problem underlies what I called inflation paranoia. The New Consensus view treats inflation as always and everywhere a problem of excess demand, to be solved by the central bank through higher rates. But the recent pandemic inflation and its more recent and milder rekindling are not fundamentally excess demand, or a wage-price spiral driven by an overheated labor market and distributive conflict. It is a cost-push episode shaped by energy shocks and the previous one by logistics problems too. Again, this is NOT the 70s show.
Warsh cannot fix cost-push inflation by hiking interest rates. He can slow the economy, weaken labor markets, and perhaps prick asset bubbles. But that is not the same thing as solving the causes of inflation. There is no significant risk of high inflation. The biased lesson drawn from the Volcker legacy is that central bankers achieve greatness by inflicting pain. The better lesson is that Warsh should not seek glory by repeating Powell’s hikes or, worse, by chasing a new Volcker myth.
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