According to new research by the Cato Institute’s Center for Monetary and Financial Alternatives, the answer to the question “Can the Federal Reserve control inflation?” is no. Jai Kedia writes at Cato:
Research by Cato’s Center for Monetary and Financial Alternatives (CMFA) shows that there is not much empirical support for the notion that the Fed can precisely control inflation.
Earlier this year, Cato published a paper that suggested monetary policy was the least important contributor to inflation, far behind both demand and supply factors in the economy. However, that paper used a simple approach (known as a VAR methodology) to study the sources of inflation. Cato CMFA’s newest research paper addresses this weakness and provides more robust evidence that the Fed cannot precisely control inflation.
Unlike the previous approach, the new working paper uses a sophisticated macroeconomic model, one that includes a variety of features to capture facets of the US economy accurately. The results are very similar to the first study—supply factors dominate the overall changes in inflation, both when looking ahead at inflation forecasts and when analyzing actual inflation in the US since 1960.
Figure 1: Main Driving Forces of US Core PCE Inflation, 1960 to 2019
As Figure 1 shows, from 1960 to 2019, monetary policy has had a limited impact on inflation, increasing with the horizon of the forecast but never exceeding 5 percent. Supply factors— particularly goods market supply factors in the short run and labor market wage factors in the long run—affect most of inflation. Supply factors together account for 85 percent to 90 percent of inflation. As Cato scholars have pointed out for decades, monetary policy is particularly helpless in the face of supply‐driven inflation.
Action Line: Trying to use price controls on money to manipulate the economy probably works about as well as other price controls on goods and services do, i.e., not well. You can’t rely on the Federal Reserve to clean up a problem it helped create. Instead, save til it hurts and try to avoid big mistakes with your money. Click here to download my free special report on the Top 10 Investing Mistakes to Avoid.
