The case for Powell

David Beckworth has an excellent piece in the NYT explaining the case for reappointing Jay Powell for another 4-year term. Since I don’t have much to add, I’ll instead focus on one part of David’s article that I agree with, but fear that some may misinterpret:

Perhaps the most important element that Mr. Powell could bring to a second term as Fed chair is humility. After taking the helm in early 2018, he oversaw four interest rate hikes motivated by a belief that the economy was exceeding its “speed limit” and might soon overheat, with undesired price increases around the corner. Mr. Powell, however, had begun doubting that the Fed actually knew the speed limit of the economy and admitted as much in an August 2018 speech. Later, after the Fed was forced to reverse itself with interest rate cuts in 2019, he acknowledged to Congress that the Fed had indeed underestimated how much room the economy had to grow.

It is rare to see a Fed official, especially a chair, admit a mistake so soon after it happens. Rather than a demerit, this willingness to learn is precisely what a president facing the uncharted waters we are in would want in a central bank leader.

This mid-course correction is an example that I often cite as a reason to be optimistic about monetary policy. Indeed before Covid hit in 2020, it was the primary reason why I thought we might finally get that elusive “soft landing”. Alas, that was not to be, but we’ve recovered so quickly that I am once again getting my hopes up for a soft landing in the 2020s. Being able to reverse course when you’ve made a mistake is one of the most important attributes of being a good Fed chair.

So why do I worry that some may misunderstand this example? My fear is that people will assume that the Fed made a mistake because it raised rates 4 times in 2018 and then turned around and cut them 3 times in 2019. That’s not why David and I view 2018 as a mistake. The natural rate of interest moves around, and the policy rate should move with it. Rather David’s appraisal is based on evidence that, in retrospect, a more expansionary policy in 2018 would have led to an outcome closer to the Fed’s target. The Fed misjudged the economy’s “speed limit”

Just so that you don’t think that I’m splitting hairs, let me throw out a claim (which David may of may not agree with), which will help to clarify what it means for the Fed to make a mistake. Fed mistakes do not occur when the Fed reverses course on interest rates, they occur when the inflation/employment outcome is unfavorable. More specifically, when the economy is far from the Fed’s target of 2% PCE inflation and high employment. And here’s my radical claim: The two years in question (2018-19) were the most successful Fed policy in my lifetime, perhaps in all of Fed history. Not one of the best pair of years, the very best.

During my lifetime, there are only a couple two year periods that look even close to 2018-19. One is 1999-2000 when inflation was equally close to 2%. But in that case the unemployment rate was higher than in 2018-19. The only other two year period with similarly low unemployment was 1968-69, but that was purchased at the cost of severe overshooting on the inflation front. So 2018-19 was the very best 2-year period.

Then why do David and I view this as evidence of a policy mistake? Because it could have been even better. If money were a bit easier in 2018, then inflation during 2018-19 would have been slightly closer to 2% and unemployment would have been a bit lower. But again, while this was a policy mistake, it was also the smallest policy mistake in modern Fed history, at least by my estimation. Every other 2-year period was worse.

Confused? Now you see why I fear some people might misinterpret this point. They might assume David is talking about the famous “Mistake of 2018” like it was some sort of huge policy blunder. If it had been a huge blunder, then the case for re-appointing Powell would be weak.

Instead, what we observed is the Fed making a small mistake in 2018, and quickly correcting the mistake in 2019. Think of a bus that is going down the highway. It drifts six inches from the center of the lane, and the driver quickly and smoothly adjusts the steering to bring it back on center. That’s a lot better than having the bus drift onto the gravel shoulder and have the driver lurch back so sharply that people lose their lunch! Powell is like a skilled bus driver, making small and agile corrections to keep aggregate demand on course.

The obvious objection to this post is that I’ve assumed all Fed chairs are dealt the same hand. That’s a fair criticism, especially regarding real shocks like the Covid recession. But most recessions in the US are caused by demand shocks, i.e. bad Fed policy. So it really does make sense to judge the Fed based on macroeconomic outcomes, at least in most cases (not in 2020).

A better objection is that the natural rate of unemployment moves around and that Powell benefited from a low natural rate in 2018-19 (compared to say the 1970s and 1980s, when the natural rate was higher.) I agree, but that just means that 2018-19 was one of the best 2 year periods ever, perhaps not the very best. The bottom line, however, is that inflation slightly below 2% and unemployment below 4% is a really good outcome, at least relative to any other period in US history.