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The writer is an FT contributing editor
Every Federal Reserve press conference follows the same pattern — in growth and stagnation, in low and high inflation. Reporters ask when the Fed will be satisfied that its tools are working. The poor Fed chair does not really have an answer and says that the central bank is watching carefully, reminding the media that monetary policy has a “long and variable lag” or words to that effect.
This was the format this week when chair Jay Powell talked to the press after another 0.75 percentage point rate rise as the Fed waits for inflation to drop. But it could have just as easily been Janet Yellen or Ben Bernanke. That exquisite phrase “long and variable lag” is a technical-sounding way of saying “we don’t know and we don’t know when we will know”.
Monetary policymakers have been saying this for so long that we have allowed them to launder it into a kind of privilege. They do not have to adapt. They do not have to be creative. Their tools do not have to work. Central bankers remain forever in lag. It is not working now — but it could.
The phrase itself derives from one of the founding documents of the current central banking regime, Milton Friedman’s 1959 A Program for Monetary Stability. Friedman pointed out that the Fed could use its balance sheet to increase or decrease the total supply of money in the economy, but peaks in inflation tended to follow peaks in the supply of money with a “considerable lag” which was also “rather variable”. This is a monetarist argument, one that has fallen out of favour among macroeconomists. But the language stuck.
In that same book, Friedman offered a full list of central bank tools. The Fed could supervise or regulate banks. It could conduct specific credit policy, encouraging or discouraging different kinds of loans. Or it could encourage or discourage credit overall, in particular by buying and selling securities on the open market.
Friedman was not the only 20th-century influence on monetary policy. But it is hard to overstate his power to define what was and was not the proper job of a central bank. In his Program, he swept supervision and specific credit policy off the table, and stated that open market operations were monetary policy.
Ben Bernanke won his Nobel this year for his historical work on the way bank collapses lead to economic collapses, as the remaining healthy banks have trouble figuring out who gets credit. It is indeed a happy coincidence that he was the Fed chair during the financial crisis, as he worked with Congress and the White House to find creative ways to keep banks from collapsing.
But Bernanke was also chair for several years after the crisis. He wrote the plans for how the Fed would think and react, not just in a crisis but in the course of its normal work. When the Fed conducted its policy review in 2019 and 2020, it did not really change anything. Jay Powell is the one speaking to the press, but it is still today Ben Bernanke’s Fed.
Bernanke increased the pace at which the Fed published its internal projections, reasoning that it was bad to surprise markets and that, in fact, it might be useful to guide them more regularly and clearly on what was coming. As other central bankers were doing, he adopted an inflation target. But Bernanke, who as a grad student had studied Friedman’s monetary history closely, also stayed within the lines that Friedman had drawn so clearly in 1959. Regulation and specific credit remained off the table as monetary policy tools. The Fed’s one tool was the desk on Liberty Street in New York where it bought and sold Treasuries and the securities of federal agencies on the open market.
The problem now is not that Friedman and Bernanke were wrong. You can be right for a time, and then when things change you do something different. But there does not seem to be any urgency at the Fed over tools. For years, the Fed failed to reach its inflation target and, well, there is a lag. These things happen. Now, using the same framework, it is not clear that the Fed is bringing inflation back down to target, leaving Powell behind the podium talking about recent research on lags.
Even Bernanke himself, in his most recent work, 21st century Monetary Policy, closes by considering tools that other central banks have tried — buying stocks and corporate bonds, offering funding for specific kinds of bank loans. He even briefly mentions buying bank loans, as the Fed did during the pandemic. But he doesn’t see the Fed pressing Congress for the regular use of these tools anytime soon, or Congress granting them.
The Fed is pulling up and down on a lever that may not be attached to anything, hoping it gets lucky. Who knows? It might. The lags are long and variable.