Jay Powell ignores Milton Friedman at his — and our — peril

Milton Friedman, the great scholar of U.S. monetary policy history, never tired of reminding us that monetary policy operates with long and variable lags.

By this he meant that raising interest rates does not have an immediate impact on the economy. Rather, it takes a long and uncertain time before Federal Reserve policy tightening influences the economy. 

{mosads}Jay Powell, the new Federal Reserve chairman, would do well to heed Friedman’s basic teaching in his efforts to keep inflation from exceeding the Fed’s 2-percent inflation target. 

In particular, he would be well advised not to wait for clear signs of inflation to emerge before he has the Fed move to a more restrictive monetary policy stance than it is presently pursuing.

If he waits for inflation to reach the Fed’s target before acting, he will have waited too long and the Fed would be almost certain to miss its inflation target given the long lags with which monetary policy tightening works.

Complicating Chair Powell’s task in keeping inflation under control, there are a number of reasons to think that Janet Yellen left him with a Fed that was well behind the interest-rate-raising curve.

Among these reasons is that both inflation and inflation expectations have been picking up considerably in a manner that could very well put at risk the Fed’s inflation target.

The latest consumer price numbers show that headline inflation is now running at 2.1 percent while core inflation has now reached 1.8 percent. Meanwhile, long-run inflation expectations, as measured in the 5-year bond futures market, has now risen to 2.2 percent or significantly above the Fed’s inflation target.

An even more compelling reason for thinking that the Fed has been too slow in raising interest rates is that the U.S. economy is now receiving substantial fiscal and monetary policy stimulus. This is the case even though the U.S. economy is very close to full employment and even though it is growing at a rate considerably above its potential.

As an indication of how expansive economic policies are, it is well to consider how loose U.S. financial conditions are at this late stage in the economic cycle.

The St. Louis Federal Reserve’s Financial Conditions Index, which takes into account not only still-low interest rates but also very buoyant equity prices and a significantly depreciated U.S. dollar, is at practically its lowest level in the past 40 years.

At the same time that the U.S. economy is being boosted by very easy financial conditions, it is also receiving a large fiscal stimulus from President Trump’s unfunded tax cuts and his recently announced public spending plans.

According to Goldman Sachs, in both 2018 and 2019, the U.S. economy could receive a fiscal boost of as much as 0.75 percent of GDP as a result of the Trump budget measures. 

Chair Powell will be under considerable pressure not to remove the punch bowl from the party by raising interest rates more rapidly than the Fed is presently planning. However, if he yields to that pressure, he risks leaving unchecked the inflationary pressures that are already building in the economy.

That in turn could invite the wrath of the bond market vigilantes, which could lead to a much more disorderly and abrupt rise in interest rates than would have occurred if the Fed, rather than the markets, took the lead in moving interest rates higher.

Hopefully, Powell will soon find the right path for an appropriate degree of monetary-policy tightening. However, if he fails to heed Milton Friedman’s teaching that monetary policy operates with long and variable lags, we should brace ourselves for a prolonged period of very unsettled financial markets.

Desmond Lachman is a resident fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.