Cochrane on the Fed

2025 06 09

Anything by Cochrane on money is going to be worth consideration. The headline, however, A New Strategy to Fight Inflation gets off on the wrong foot. Inflation is not for “fighting;” it’s for “managing.” Sometimes we need more infation (to facilitate relative price adjustment to shocks when some nominal pries are downwardly sticky) and sometimes less (to return to target after the adjustment to the shock). The trick is make sure that market participants remain confident that returning to target is the objective notwithstanding needed episodes of over-target.

Fortunately, the text is more nuanced than the headline (which nay not have been hosen by Cochrane). The topic is the Fed’s reconsideration of its strategy. Concerning which Cocrane observes, “

The previous “flexible average inflation targeting” [FAIT] strategy was a beautifully constructed Maginot line against the Fed’s fear of deflation at zero interest rates.

Cute, but not very insightful. FAIT is about temporarily pushing inflation above target regardless of the interest rate and has nothing in particular about avoiding deflation. Perhaps the Fed could have responded to COVID faster than it did and avoided the short episode of disinflation in 2020; it is a stretch to attribute the failure to FAIT.

On the other hand, this is near spot on:

The recent inflation was a choice, made in difficult circumstances. An honest Fed and government [and government?] would say, “We thought we faced a calamity. … We faced huge supply shocks. We met them with inflation to avoid a severe recession. You’re welcome.” That they do not do so suggests a certain regret about choices.

A more _forthright_ Fed would say … The fed has never explained its rationale for FAIT and that yes it means explaining that higher inflation is sometimes sought not always fought. And it might imply giving its ex-post account of how much over target inflation it now believes was necessary (all?) and assessment of when it should have begun pulling in the reins (March 2021?). But this woud be huge change in its traditional pose and a huge shock to the public’s perception of a heroic Fed constantly struggling with the inflation monster – Heracles and the Hydra, Perseus and Medusa, Beowulf and Grendel.

Looing forward,

Tariffs and trade war, if not swiftly abandoned, will be another stagflationary “supply” shock, raising prices while reducing the economy’s productive capacity. The Fed will face an unhappy choice between more inflation and somewhat less contraction.

Hopefully it will chose not to allow a failure to adjust to the supply shock to compound the fall in real income from the tariffs, choosing higher inflation, instead. But this will not be easy:

Easing voices want the Fed to again “look through” another price level increase that is not forecast to produce continuing inflation. But people are really mad about higher prices, even though “transitory” inflation has faded.

What does Cochrane recommend

In the last review, the Fed committed to make up undershoots with more inflation to bring prices back. The Fed should make that symmetric: Promise now to make up any overshoots with lower inflation, to gently bring back the level of prices. Confidence in lower prices ahead can restrain inflation now.

But it was always symmetric, higher inflation during adjustment to the shock and lower to return to target. Could he seriously mean disinflation to return the rice level to the pre-shock value? If the target has been chosen as the minimum level to inflation needed to achieve maximum income growth, under target not to mention disinflation is a recipe for recession.

Additionlly:

• Use independence. The Fed can say no to buying trillions of Treasury debt, to holding down interest rates, to financing Treasury handouts, to lower rates in order to weaken the dollar.

That is, hold to its FAIT policy without regard to the fiscal deficits. Maintain monetary dominance.

• Distrust forecasts. They were dramatically wrong before and will be wrong again.

[??? ]

• But react quickly to inflation when it breaks out. No more waiting for “transitory” inflation to disappear. Promise quick “data dependent” reaction, not a fixed path for rates.

A quick, data dependent reaction with no fixed path for interest rates yes, but whether the objective is less inflation or more.

• Tolerate relative price movements. Some prices and wages going down when others go up is not the end of the world, requiring a perpetual inflationary bias.

Tolerate, nay facilitate relative price movement but this requires a “inflationary bias” when some nominal prices are sticky. The alternative is a “recessionary bias.”

• Remove the financial hostage. Higher interest rates or a recession threaten banks again, and another bailout. Get interest rate exposure and huge leverage out of the financial system.

This is a job for regulators. Banks have no business making significant interest rate bets. If they do term transformation regulators should insist they do it with variable rate instruments.

His recommendations to government are positive, but vague and weak:

• Forswear stimulus. Everyone can see the Covid and post-Covid spending was overdone. Prepare to spend wisely, on measures that clearly and narrowly address the crisis at hand.

Yes. Regardless of shocks, stick to (if we could ever achieve) holding defcits to no more than public investment, activities with net present values >0. This, in recession, would mean “spend[ing] wisely, on measures that clearly and narrowly address the crisis at hand”

• Borrow long. If the Fed raises rates, interest costs on the debt rise. That adds to the deficit and can boost inflation. Move the treasury to long-term borrowing, and coordinate with the Fed not to throw away that insurance with bond purchases.

“Nolo contendere”

• Restore fiscal space. To borrow in a crisis, without driving up interest rates or inducing inflation, the government needs to assure investors that additional borrowing can and will be paid back by tax revenues or spending cuts. Tax, spending, and growth reform buy good credit.

Out with it John. We know you mean, you know we need a significant decrease in annual deficits even though that will mean higher taxes for your WSJ readers. Tell them. 😊

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Image prompt: Cochrane’s own icon

[Standard bleg: Although my style is know-it-all-ism, I am aware that I could be mistaken or overstate my points. I would, therefore, welcome comments on these views.]