Commentary on Political Economy

Wednesday 13 October 2021

 Is Fed’s Inflation View Built on Sand? A Staffer Suggests So, Stirring Debate About Economics

Critique from the Federal Reserve’s own professional ranks accuses economists of making assumptions to suit their theories

Federal Reserve Chairman Jerome Powell predicts inflation will soon return to the Fed’s 2% target. PHOTO: STEFANI REYNOLDS/BLOOMBERG NEWS


Oct. 13, 2021 11:29 am ET

“Mainstream economics is replete with ideas that ‘everyone knows’ to be true, but that are actually arrant nonsense.”

That’s not a pundit’s tweet or an academic’s blog post. It’s the opening line of a research paper released by the Vatican of mainstream economics, the Federal Reserve.

Staff economist Jeremy Rudd’s paper focuses on a purported flaw in the Fed’s sanguine outlook for inflation. But his critique extends to the entirety of the field, accusing economists of routinely making assumptions because they suit their models and theories, not because they fit the facts.

This isn’t a new criticism. This week the Canadian-born economist David Card, now at the University of California, Berkeley, shared in the Nobel Prize in Economic Sciences for seminal research nearly three decades ago that found, contrary to textbook models of the labor market, a higher minimum wage didn’t reduce low-wage employment.

Economist David Card, who won the 2021 Nobel Prize for Economics, speaking at the University of California, Berkeley, on Monday. PHOTO: BRITTANY HOSEA-SMALL/UC BERKELEY/VIA REUTERS

Mr. Card and fellow laureates Joshua Angrist and Guido Imbens were recognized for pioneering research methods, specifically “natural experiments.” These typically tease out the effect of a policy intervention on a population by comparing it with a similar, untreated population. Mr. Card and co-author Alan Krueger, who died in 2019, compared employment of fast-food workers in New Jersey, where the minimum wage rose, to Pennsylvania, where it didn’t.


Their greater legacy, though, may have been to topple the centrality of theory to economics. Mr. Card and Mr. Krueger noted in 2016 that at the time empirical analysis appeared in less than 40% of economics papers and usually to “confirm the basic prediction of a theory” rather than “test…the underlying economic model.” They added: “Economics cannot claim to be a scientific field if its main theories are not subject to empirical testing and possible rejection.”

Nowadays, the populist right and the progressive left regularly attack economists as tone-deaf elitists dressing up free-market dogma as science. In a decidedly un-central bankerly footnote, Mr. Rudd hints he may agree: “I leave aside the deeper concern that the primary role of mainstream economics in our society is to provide an apologetics for a criminally oppressive, unsustainable, and unjust social order.”

Labor economist Alan Krueger, who died in 2019, studied the centrality of theory to economics. PHOTO: LARRY DOWNING/REUTERS

While Mr. Rudd may lack the stature of this week’s Nobel laureates, his critique of Fed policy has stirred a hornet’s nest because it comes from within the Fed’s professional ranks, typically known for technical acumen, not polemical flourish. He’s worked at the Fed since 1999. Former colleagues describe Mr. Rudd as thoughtful, reserved and “somewhat geeky.”

“He’s quite a quiet economist most of the time,” said Jonathan Wright, a former colleague now at Johns Hopkins University. “At the same time, he can issue these thunderbolts.” (Through a Fed spokesman Mr. Rudd declined to be interviewed.)

His critique starts in the 1960s when future Nobel laureates Milton Friedman and Edmund Phelps separately hypothesized there was some natural level of unemployment determined by the structure of the economy. Monetary or fiscal stimulus could temporarily push unemployment below this level and raise inflation. But eventually, rational workers would expect higher inflation and demand higher wages to compensate, so unemployment would go back up.

Economists have debated the effects of inflation on employee wages for years. PHOTO: BRANDON BELL/GETTY IMAGES

As Mr. Rudd notes, Mr. Friedman and Mr. Phelps weren’t explaining contemporary events but satisfying the demands of theory, namely that inflation couldn’t consistently fool rational people into working harder. Events seemed to bear them out: In the 1970s, inflation and unemployment both rose. Since the mid-1990s inflation has fluctuated around 2%. Most economists and the Fed attribute that to the public expecting inflation to always revert to 2% and thus not changing price or wage setting behavior in response to temporary disturbances.

Today, pandemic-related bottlenecks and commodity shortages have pushed inflation above 5%. But because surveys and bond markets show inflation expectations haven’t moved much, Fed Chairman Jerome Powell thinks that jump is temporary and predicts inflation will soon return to the Fed’s 2% target.

Mr. Rudd, though, argues the evidence simply doesn’t show expectations actually drive inflation. Key predictions by those early scholars turned out wrong, and there are more plausible reasons inflation has stayed low than stable expectations, he says. He argues public behavior changes when actual, not expected, inflation is high. External events brought actual inflation down by the early 1990s and the public accordingly stopped paying attention.

Mr. Rudd’s work implies that with actual inflation now so high, the public could start paying attention. High inflation will thus prove more persistent than Mr. Powell thinks.


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Mr. Wright thinks Mr. Rudd’s critique is off base. He said central banks have always assumed expected inflation is heavily influenced by actual inflation and Mr. Rudd ignores Europe and Japan whose inability to get inflation up is best explained by expectations.

Economic models do indeed typically assume people act rationally, but Mr. Wright said without such theoretical foundations, economics has no anchor: “You can claim anything.”

That’s already evident in the minimum wage debate. Because studies show small increases don’t hurt employment, advocates claim large increases, such as to $15 an hour, won’t either. By that logic the minimum could rise to $20 or $30 without ever hurting jobs. If inflation expectations don’t matter, then high inflation is here to stay unless the Fed raises interest rates now and accepts the cost of forgone income and jobs.

Ultimately, evidence and theory matter less to good decisions than being open minded enough to know when either leads you astray. The most encouraging aspect of this latest attack on Fed policy is that the Fed itself was willing to publish it.

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