The Fed Is No Longer the Only Game in Town

(Bloomberg Opinion) -- Last week’s meeting of central bankers in Jackson Hole was a kind of victory lap for the Fed. It may have also marked the peak of its power.

The US Federal Reserve’s recent successes are undeniable: Inflation seems to be under control and fears of a recession are fading, allowing the bank to start normalizing interest rates. But a research paper presented last week suggests this may be the Fed’s swan song. In the coming years, it is likely to get weaker, the result of two separate but related developments — one positive, the other negative.

In the last few decades, the Fed has gained extraordinary power over the US economy. This is in part because the federal government was seen as ineffective. Part of the hands-off approach was deliberate; policymakers were wary of micromanaging the economy and were mostly supportive of free trade. And even as deficits rose, there was at least some fiscal restraint — especially after the financial crisis and recession that followed. As my Bloomberg Opinion colleague Mohamed El-Erian noted, the Fed was the only game in town.

As a result, many people looked to the Fed to expand its scope outside its traditional dual mandate of keeping inflation and unemployment low. They wanted the bank to take on challenges such as reducing the structural rate of unemployment, inequality and even climate change.

That era is now ending. In their paper, three economists from New York University, Stanford and London Business School argue that the US is moving from a regime of “monetary dominance” to one of “fiscal dominance.” In the former, the Fed controls inflation by adjusting short-term nominal interest rates. The government supports these efforts by committing to increase future taxes, ensuring that other interest rates don’t change too much and debt doesn’t overwhelm markets. Under a monetary dominance regime, interest rates and inflation are low and relatively stable.

The regime changed during and after the pandemic, when wartime-sized debt was issued with no care of paying it back. As a result, interest rates increased and became much more volatile, the correlations between stocks and bonds flipped, and inflation returned — all hallmarks of a fiscal-dominance regime.

Under such a regime, the Fed is less powerful. It has to manage regular bouts of inflation and faces real trade-offs between managing the labor market and inflation. Not only is its job harder, but its tools are less powerful — it has less influence over interest rates. After spending moderated and monetary policy became more restrictive, the US returned to a monetary policy regime. But the nation’s debt trajectory risks a future turn to fiscal dominance.

And yet it is not all bad news for the Fed. Yes, the sheer size of fiscal policy undermines the power the bank should have — but the scope of fiscal policy is changing for the better.

Fiscal policy, which has become more ambitious in recent years, is finally doing the job it’s supposed to do. Both parties have been vocal in supporting policies that aim to shift production from services to manufacturing, either through tariffs or with industrial policy. There are also goals related to improving infrastructure, lowering the cost of housing, and reforming the immigration system. These policies change the supply side of the economy, which will influence the rate of growth, inflation and the structural rate of employment — all objectives that, just a few years ago, the Fed was expected to take on.

In some ways this is a better model, even though I myself favor a more market-friendly approach. Industrial policy, tariffs and excessive debt can lead to a slower and less productive economy. The best option is a monetary dominance regime and a government that aims to expand the supply side of the economy with pro-growth policies that don’t require so much debt.

Still, arguments over the proper size and role of government aside, one thing it should be doing is taking on the supply side, facilitating growth and enacting policies that affect the distribution of resources. Not only does it have better tools to do this, but the government — unlike the Fed — is also accountable to voters.

It is neither advisable nor sustainable for the Fed to be the only game in town. It can smooth out the bumps in the business cycle and manage inflation expectations, but over the long term, the Fed needs to maintain independence. When it takes on a bigger role in the economy, it jeopardizes that independence. At the same time, high-debt policies that risk a return to a fiscal-dominance regime also undermine the Fed’s independence.

It’s good that the government is emphasizing the supply side of the economy — and is at least attempting to stimulate production. Its success will be judged by voters, as it should be. But it also needs to focus on managing its debt.

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Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.”

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