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Is the New Bipartisan Consensus on Interest Rates an Illusion?

Alexandria Ocasio-Cortez
Alexandria Ocasio-Cortez Photo: Anna Moneymaker/Getty Images

On Wednesday, in a House Financial Services Committee hearing, Representative Alexandria Ocasio-Cortez walked through the Fed’s repeated reductions in its estimate of the natural rate of unemployment — a figure that’s important, because it informs how the Fed decides whether we’re at full employment and therefore whether it might need to raise interest rates in order to contain inflation.

Ocasio-Cortez noted the Fed thought, in 2014, that this figure was 5.4 percent. They cut the estimate until it fell into the low fours, and now actual unemployment is 3.7 percent. And yet, even by Fed Chairman Jerome Powell’s admission, we manage to have unemployment that low without a “hot” job market that produces rapid wage growth. Is it possible the Fed had erred in these past estimates, Ocasio-Cortez asked?

“Absolutely,” responded Powell.

The implication of this exchange — that the Fed has systematically misjudged the relationship among interest rates, inflation, and unemployment for years — has gone rapidly from an unpopular view to a consensus one. Top White House economic adviser Larry Kudlow praised Ocasio-Cortez for her observation.

This is a welcome shift, but it’s worth asking how durable a shift it is, given the asymmetrical way in which the two parties approach economic policy.

From a cynical perspective, you might expect the party in power to favor low rates even when they are inappropriate, since they can boost the economy in the short term even when they pose undue inflation risk. On the other hand, you would expect the out-of-power party to call for higher rates, to constrain positive economic trends that threaten to bolster the president politically.

Indeed, this is something Democrats tend to suspect was happening when Obama was president and conservatives routinely decried the Fed as too loose, printing money, debasing the dollar, propping up a “fake economy” and such. Yet Democrats have continued to drift in a dovish direction on interest rates even though they have lost control of the presidency. It’s hard to find Democrats defending the modest campaign of rate hikes the Fed was actually implementing until the end of last year, let alone demanding more rate hikes.

The Republican shift on monetary policy is easy to put in a cynical frame. When a Democrat was president, they were for high rates. Now that a Republican is president, they want low rates. This state of affairs looks like a straightforward example of what Jonathan Chait calls “the hack gap.” And I do think this is part of the picture, but not its entirety.

The conservative voices who have gained influence in the last couple of years urging a more dovish rethink of monetary policy — for example, commentators like Scott Sumner, Ramesh Ponnuru, and Karl Smith — were trying to talk the hawks off the ledge long before Trump became president. Their ideas, plus the actual experience of setting interest rates at zero for a decade and not experiencing high inflation, seem to have influenced the views of conservative policymakers associated with the Fed, like Minneapolis Fed president Neel Kashkari, and arguably Powell himself. The timing here supports the idea of sincere changes in views: Kashkari, for example, was already critical of rate hikes in 2016, before Republicans knew they would gain the presidency.

The hacks are still around, of course. Steve Moore, Herman Cain, and Judy Shelton, each of whom President Trump has sought to place on the Federal Reserve Board, have all in the past held extreme hawkish views, including support for a metallic currency standard. They have not provided a convincing account of their dovish conversions. And congressional Republicans, who use to routinely excoriate the Fed for excessive ease under Obama, are now barely a presence in monetary-policy discussions at all. It is very easy to see them all snapping back to a loud, hawkish position under the next Democratic president, even if policymakers like Kashkari have changed for good.

The risk for liberals is building a regime where political conditions support appropriately accommodative monetary policy under Republican presidents but not Democratic ones. So, for people on both the right and left who genuinely favor a more balanced approach to monetary policy and want to see it endure, the question is how to strengthen the emerging consensus and make it more robust against changing political incentives.

I’m not sure what the answer is, but I think a key part of the strategy has to be encouraging and reinforcing the already-underway shift in perspective within the central bank. The institutional Fed has shown an ability to defend policies such as quantitative easing even under political attack, and institutional perspectives within the Fed have had remarkable staying power across decades, even as the political party of the president appointing Federal Reserve Board members changes. So as the emerging conventional wisdom comes to be shared not just by AOC and Larry Kudlow but by members of the Fed board itself — and you can see the board moving that direction, including with Powell’s “absolutely” answer this week — a new institutional perspective could prove as self-perpetuating as the old ones have been, even in the face of electoral and political changes in Washington.

Is the Bipartisan Consensus on Interest Rates an Illusion?