The Fed was designed for a supply-side economy. In the current populist era, structural inflation is driven by political demands for wealth redistribution and 'fairness.' The Fed's tools only benefit the wealthy and cannot address this core political issue, rendering it powerless, much like it was in the 1970s.
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Recent inflation was primarily driven by fiscal spending, not the bank-lending credit booms of the 1970s. The Fed’s main tool—raising interest rates—is designed to curb bank lending. This creates a mismatch where the Fed is slowing the private sector to counteract a problem created by the public sector.
Due to massive government debt, the Fed's tools work paradoxically. Raising rates increases the deficit via higher interest payments, which is stimulative. Cutting rates is also inherently stimulative. The Fed is no longer controlling inflation but merely choosing the path through which it occurs.
'Fiscal dominance' occurs when government spending, not central bank policy, dictates the economy. In this state, the Federal Reserve's actions, like interest rate cuts, become largely ineffective for long-term stability. They can create short-term sentiment shifts but cannot overcome the overwhelming force of massive government deficit spending.
When government spending is massive ("fiscal dominance"), the Federal Reserve's ability to manage the economy via interest rates is neutralized. The government's deficit spending is so large that it dictates economic conditions, rendering rate cuts ineffective at solving structural problems.
The Fed's tool of raising interest rates is designed to slow bank lending. However, when inflation is driven by massive government deficits, this tool backfires. Higher rates increase the government's interest payments, forcing it to cover a larger deficit, which can lead to more money printing—the root cause of the inflation in the first place.
The modern economic structure is morally flawed. It pushes people from housing, the only asset they understand, into the stock market, then erodes their wealth via inflation. This act of "stealing" from citizens through monetary policy creates the economic insecurity that fuels populism.
Government money printing disproportionately benefits asset owners, creating massive wealth inequality. The resulting economic insecurity fuels populism, where voters demand more spending and tax cuts, accelerating the nation's journey towards bankruptcy in a feedback loop.
Alan Blinder notes that politicians, driven by electoral cycles, lack the will to use fiscal tools (like tax hikes or spending cuts) to cool an overheating economy. The last instance was in 1968 under President Johnson, underscoring why an independent central bank is the only reliable institutional defense against inflation.
The Fed faces a political trap where the actions required to push inflation from ~2.9% to its 2% target would likely tank the stock market. The resulting wealth destruction is politically unacceptable to both the administration and the Fed itself, favoring tolerance for slightly higher inflation.
By engaging in large-scale asset purchases (QE) for too long, the Federal Reserve inflated asset prices, creating a two-tier economy. This disproportionately benefited existing asset holders while wage earners were left behind, making the Fed a major, albeit unintentional, contributor to wealth inequality.
