PALO ALTO Calif. (Reuters) - The U.S. Federal Reserve does not have the power to fight inflation on its own, a prominent economist said on Thursday, a conclusion that challenges the very bedrock of current Fed thinking.
“Inflation is always and everywhere a fiscal problem,” declared John Cochrane, a professor at the University of Chicago, speaking at Stanford University’s Hoover Institution. “Long-run price stability is a function of the structure of government debt, ﬁscal promises, and ﬁscal commitments. The central bank has only a short-run smoothing role, as it did under the gold standard.”
That view is heresy at the Fed, which has since 2012 targeted 2-percent inflation. “The inflation rate over the longer run is primarily determined by monetary policy,” it said at the time in a statement crafted by Fed Chair Ben Bernanke and Janet Yellen, who has since become the head of the Fed.
Cochrane was one of several scholars who used the conference to take aim at conventional Fed thinking.
San Francisco Fed chief John Williams and Richmond Fed chief Jeffrey Lacker, seated next to each other in the front row, were among the conference’s 100 or so attendees. Both are to speak on Friday, along with Philadelphia Fed President Charles Plosser. Kansas City Fed Chair Esther George is set to address the group over dinner on Thursday.
To Cochrane, inflation targeting is actually a “fiscal promise” to raise taxes or to cut spending should inflation rise too fast.
Indeed, he said, the Fed’s success in defeating runaway inflation under Fed Chair Paul Volcker during the 1980s was only possible because of cooperation from fiscal authorities.
In a separate presentation, University of Houston’s David Papell argued that the economy has historically fared better when the Fed follows monetary policy rules, from which Papell said it is currently deviating.
The conference was put together by John Taylor, a prominent critic of the Fed’s super-easy monetary policies. He is also the author of one such well-known rule.
Yellen said in April that while she believes the Fed should react in a “systematic manner” to blunt shocks, doing so during the disruptions and aftermath of the financial crisis has been challenging.
San Francisco Fed’s Williams, who sat silent during Cochrane’s paper, raised his hand after Papell’s presentation.
“The difficulty with this whole methodology is that it really, I don’t think, passes the, kind of, sniff test,” he said, noting that the period during which Volcker raised rates to defeat inflation was a period of “huge deviation” from policy rules.
A few minutes later, Cochrane stood to question the paper’s methodology, but from a different vantage point.
The Fed in January abandoned its promise to keep rates low until unemployment falls to a certain point, and instead said, in Cochrane’s words, “We promise to do whatever the hell we feel like doing when the time comes.” But interest rates, currently near zero, barely budged, calling into question the idea that deviating from rules-based policies produces bad results.
Reporting by Ann Saphir; Editing by Lisa Shumaker