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.
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Rajan suggests that a central bank's reluctance to aggressively fight inflation may stem from a fear of being blamed for a potential recession. In a politically charged environment, the institutional risk of becoming the 'fall guy' can subtly influence policy, leading to a more dovish stance than economic data alone would suggest.
The Fed's latest projections are seemingly contradictory: they cut rates due to labor market risk, yet forecast higher growth and inflation. This reveals a policy shift where they accept future inflation as a necessary byproduct of easing policy now to prevent a worse employment outcome.
The Federal Reserve's anticipated rate cuts are not merely a response to cooling inflation but a deliberate 'insurance' policy against a weak labor market. This strategy comes at the explicit cost of inflation remaining above the 2% target for a longer period, revealing a clear policy trade-off prioritizing employment over price stability.
Increasing political influence, including presidential pressure and politically-aligned board appointments, is compromising the Federal Reserve's independence. This suggests future monetary policy may be more dovish than economic data warrants, as the Fed is pushed to prioritize short-term growth ahead of elections.
Technological innovation should naturally cause deflation (falling prices). The Fed's 2% inflation target requires printing enough money to first counteract all technological deflation and then add 2% on top, making the true inflationary effect much larger than officially stated.
Despite conflicting inflation data, the Federal Reserve feels compelled to cut interest rates. With markets pricing in a 96% probability of a cut, failing to do so would trigger a significant stock market shock. This makes managing market expectations a primary driver of the policy decision, potentially overriding pure economic rationale.
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.
The Federal Reserve’s decision to end Quantitative Tightening (QT) is heavily influenced by a desire to avoid a repeat of the 2019 funding crisis. The 'political economy' of the decision is key, as the Fed aims to prevent giving critics 'ammunition' by demonstrating it can control short-term rates.
Ongoing political pressure, including attempts to remove a governor and uncertainty over the next Fed Chair, is perceived as a threat to the Federal Reserve's independence. This political risk is a key factor leading to the view that inflation break-evens are too low and their risks are skewed to the upside.
The Federal Reserve can tolerate inflation running above its 2% target as long as long-term inflation expectations remain anchored. This is the critical variable that gives them policy flexibility. The market's belief in the Fed's long-term credibility is what matters most.
