The Three Minds Leading the Fed’s Inflation Rethink

Kevin Warsh came to the chairmanship of the Federal Reserve a harsh critic of the central bank’s recent inflation record: more than five years above the 2% target.

He hasn’t yet detailed how he would approach inflation differently. He has, however, convened several task forces, one of which will examine how the Fed “understands and responds to the drivers of inflation.” Its three leaders’ recommendations could be a chance for Warsh to put a new stamp on how the central bank tackles rising prices.

They will have their work cut out for them. Economists inside and outside the Fed disagree on what drives inflation surges, and how best to watch for and respond to them. The panelists’ past work suggests they may recommend that fiscal policy, fighting financial bubbles and tracking the money supply play a larger role in Fed thinking than they have in recent times.

The Fed has said the task forces will “produce rigorous findings” for its policy committee to review, potentially by the end of the year. For the task force members to persuade the Fed, they may first need to persuade each other: no simple matter for these illustrious but ideologically diverse economists.

Mankiw is perhaps the best-known member. He is a longtime Harvard professor and author of a bestselling economics textbook. He was also chairman of the Council of Economic Advisers in the George W. Bush White House, where he worked with a young Warsh, also a Bush adviser. Mankiw is considered a leader of a school of economic thought called New Keynesianism.

In the years after World War II, policymakers drawing on the work of British economist John Maynard Keynes felt assured they could fine-tune the economy: More spending and lower interest rates would boost jobs and growth while elevating inflation, while tighter budgets and higher rates would slow growth and tamp down inflation.

But in the 1970s, a bout of high inflation and slow growth—known as stagflation—discredited Keynesian prescriptions. Once the public comes to expect higher inflation, wages and prices can adjust so that stimulative policies no longer raise output or lower unemployment.

New Keynesians like Mankiw adapted the Keynesian model to include this expectations phenomenon, while maintaining that prices and wages in the real world adjust slowly. Changing prices and wages can be a hassle, or be bound by contracts, so prices can actually be “sticky.” As a result, government policies can still affect output and employment in the short run.

This model is still at the heart of how most central bankers think about the inflation process. Raising interest rates weakens demand and, with a lag, the tendency of prices and wages to rise; lowering rates does the opposite. Anchored expectations make prices and wages less sensitive to swings in demand.

In 2024 remarks, Mankiw offered some color around his inflation views. Although there is an inexorable trade-off between unemployment and inflation in the short run, he said, it isn’t a dial that the Fed can easily turn at will. Even identifying the cause of inflation is difficult in the moment, he said.

Mankiw also said he has warmed to the idea of studying the money supply (captured through aggregates such as M2) to better understand inflation trends. He noted that this may have offered early hints of the 2020s inflation surge.

A focus on the money supply, championed in the 20th century by Milton Friedman, has fallen out of favor with the modern Fed. But Warsh has shown interest in this approach.

A Nobel Prize-winning academic economist, Sargent helped topple the original Keynesian model of inflation.

Along with other economists such as Robert Lucas, Sargent, now at New York University, elevated the role of “rational expectations.” That’s the theory that argues a central bank that consistently keeps policy loose to boost growth will discover that the coming inflation has been priced in, leaving prices higher without generating more employment.

Some economists believe central banks have vast power to steer inflation. But Sargent’s work has drawn attention to the role that the government’s fiscal policy can play in driving inflation, too. In a study of the hyperinflation that ravaged Austria, Hungary, Poland and Germany after World War I, he found that in order for prices to stabilize, it took serious, systemic reforms that covered both government finances and monetary policy.

If governments lose hold of their finances, the outlook is stark, in Sargent’s telling. He and a co-author used “unpleasant monetarist arithmetic” to show that if people don’t believe their government will eventually raise enough taxes to pay back debt, the central bank can be powerless to stop inflation. In that world, raising interest rates would merely raise the government’s debt burden further and require yet more money printing. That’s a sobering thought given America’s surging federal debt.

Like other recent Fed chairs, Warsh has so far refrained from commenting on fiscal policy. But Sargent’s work suggests that the Fed may have no choice but to take the growing debt into account.

White rose through the ranks at the central banks of the U.K. and Canada, then held senior roles at the Bank for International Settlements, which coordinates among global central banks, and the Organization for Economic Cooperation and Development, a club of 38 wealthy countries.

By his own description, White holds contrarian views about central banking. “I have been a dissenter from orthodox monetary policy beliefs for some decades,” he wrote in a report published in June.

Most central banks consider preventing financial crises important, but secondary to getting inflation and employment right. If unemployment is high or inflation too low, they will keep monetary policy easy, without worrying too much about how markets respond. If an asset bubble forms then pops, central banks will deal with the aftereffects later.

In White’s eyes, however, allowing financial bubbles to form and then pop is central banking’s original sin. The assurance that the Fed will cut rates to cushion the economy from a burst bubble encourages investors to make the bad bets that inflate bubbles in the first place, he argues, leaving the economy prone to boom-and-bust cycles.

At the Fed’s annual Jackson Hole conference in 2003, he and a co-author warned a hands-off approach could create financial imbalances vulnerable to a sudden collapse. To some, the 2008 financial crisis bore out White’s thinking.

White’s guidance would likely lead to tighter monetary policy than the Fed has actually adopted in recent decades. That’s because policymakers should, according to White, be willing to “lean against credit excesses” with higher interest rates even if it pushes inflation below target and leads to more frequent, brief recessions.

That may sit awkwardly for Warsh who, shortly before joining the Fed, argued that surging investment in artificial intelligence will fuel a productivity boom that can reduce inflation and allow the Fed to cut interest rates.