The Fed's Mind Control

The idea that monetary policy shapes inflation expectations is about to get road-tested

- Matthew Boesler

At his Jan. 11 hearing for confirmation to another four years at the helm of the Federal Reserve, Jerome Powell told the Senate Banking Committee that tighter monetary policy “really should not have negative effects on the employment market.”

That assertion, echoed by Powell’s prospective No. 2, Lael Brainard, in her own appearance before Congress the same week, puts the Fed’s policymakers at the center of a debate among economists that stretches back decades about the link between interest rates, employment, and inflation—in other words, how the central bank’s toolkit actually works and, for that matter, what determines the course of inflation itself.

Fed officials are walking a tightrope as they lay the groundwork for a series of interest-rate increases that could begin as soon as March. They’re heeding calls to quell the fastest consumer price inflation in 40 years while at the same time trying to avoid the appearance of penalizing workers at a moment when they’re enjoying historic bargaining power, widely seen as long overdue.

The inflation expectations doctrine that’s dominated mainstream economics since the 1980s offers one potential way to square that circle. The idea is that if a central bank can convince businesses and consumers it will maintain low and stable inflation, then it won’t have to do much else. That’s because expectations about where prices are headed are thought to be a major driver of inflation itself. If workers don’t anticipate higher inflation, they won’t demand bigger wage increases to make up for their lost purchasing power. Nor will they rush to go out and buy things because they expect them to increase in price, leading to a self-perpetuating upward spiral.