US monetary policy and the recent surge in inflation

Federal Reserve policy in the wake of the COVID pandemic has been widely criticized as responding too slowly to surging inflation and an overheated labor market, thereby exacerbating the inflation problem and impairing macroeconomic performance more generally. This paper challenges this view by exploring the likely effects of a markedly more restrictive counterfactual monetary policy starting in early 2021. Under this policy, the Federal Open Market Committee (FOMC) would have strictly followed the prescriptions of a benchmark policy rule with labor utilization gauged using the ratio of vacancies to unemployment, thereby causing the federal funds rate to rise faster and by much more than it actually did. In addition, consistent with the alternative rule-based strategy, the FOMC would have provided less accommodative forward guidance than what it implicitly provided over time, based on the post-COVID evolution of the economic projections made by FOMC participants and major financial institutions. Finally, the Fed would have ended its large-scale asset purchases earlier and begun shrinking its balance sheet sooner. Because of uncertainty about inflation dynamics, simulations of the effects of the counterfactual policy are run using different specifications of the Phillips curve drawn from recent studies, with each in turn embedded in a large-scale model of the US economy that provides a detailed treatment of the monetary transmission mechanism. Using a range of assumptions for expectations formation and the interest sensitivity of aggregate spending, the various model simulations suggest that a more restrictive strategy on the part of the FOMC would have done little to check inflation in 2021 and 2022, although it probably would have sped its return to 2 percent thereafter. Because the modest reductions in inflation suggested by these simulations would have come at a cost of higher unemployment and lower real wages, the net social benefit of a more restrictive policy response on the part of the FOMC seems doubtful; the paper also questions the wisdom of a more rapid and pronounced tightening on risk-management grounds.