As the year wraps up, several things are clear in an otherwise confusing economic picture: the U.S. economy is slowing, the stock market is surging, most people according to polls believe that inflation remains a severe issue, and the mandarins at the Fed who are responsible for containing inflation are still concerned about inflation. But what is far from clear is whether in its dedication to bringing inflation back to its 2% target the Fed is following a rigid script rather than honoring their overall mandate to ensure economic stability. Or to put it bluntly, in cleaving slavishly to a specific number, is the Fed sacrificing a stable economy on the altar of abstract theory?
[time-brightcove not-tgx=”true”]
At its last meeting of 2023, the Federal Reserve board held interest rates steady and affirmed its commitment to be diligent in its fight against inflation. While financial markets are pricing in a strong likelihood that the Fed will begin to cut interest rate target by the late spring of 2024, the actual language of the Fed and its governors tells a different story: they will hold to their stance that reaching that 2% target is non-negotiable and that until inflation is unambiguously heading back to that, rates will remain high.
In fact, one Fed governor, Michelle Bowman, thinks that rather than cutting rates or holding them at 5.5%, it may be necessary to increase rates again. “My baseline economic outlook continues to expect that we will need to increase the federal funds rate further to keep policy sufficiently restrictive to bring inflation down to our 2% target in a timely way,” she said in November. Given that there’s already evidence in the cooling job market and slowing wage growth that economic activity is decelerating in the wake of the most aggressive Fed interest rate policy in decades, further rate increases could well be enough to tip a finely balanced economy into both a recession and a deflationary spiral.
You would think that the repeated invocations of the 2% target for inflation is based on careful economic theory developed over many years of research. You would think that anchoring the entire framework of setting short-term interest rates and monitoring the supply of money would rest on solid foundations meticulously designed. But you would be wrong. Targeting inflation, let alone setting that target at 2%, goes all the way back to…2012.
That’s not a typo: targeting inflation at 2% and then orienting monetary policy to achieve that rate has existed for barely more than a decade.
Before 2012, there was no stated inflation target, and indeed, it was an open and hotly debated question whether setting specific targets was even a good thing. In the late 1980s, the New Zealand central bank like most central banks worldwide had worked assiduously to bring down the double-digit inflation that afflicted many developed countries from the mid-1970s until the early 1980s. When asked in a television interview what he thought should be a sustainable, healthy level of inflation, the New Zealand finance minister stumbled for a moment and said that it should be around 1%. That was then refined by the bank staffers to 2%, which was officially adopted as a target in the 1990s by other central banks and then made its way into the Federal Reserve staff. But not until 2012 did the U.S. Fed led by then-Chairman Ben Bernanke set 2% as a stated target.
Before he was appointed to the Fed, Bernanke as an academic was a proponent of inflation targeting both as a way to make policy more transparent and as a communications strategy to signal to markets what inflation expectations should be. Bernanke himself was sensitive to the risks that by setting a specific number, banks might become unduly beholden to that number at the expense of adjusting to fluid and often complicated circumstances that might require more nuanced approaches. But as is so often the case, as the 2% number has become set, nuance has quickly disappeared, and the number has instead become sacrosanct as if it were handed down by some economic god giving tablets to appointed Fed prophets.
There are at least two problems with the current number. One is that it rests on an assumption that people’s inflation expectations are a key factor in inflation. The thinking goes that if a person assumes that something will cost more tomorrow than today, they might either demand higher wages or buy more now, which pushes up the cost of goods by elevating demand. Or companies might try to raise prices now in anticipation of higher costs later. Yet while the belief that inflation expectations are integral to inflation rates has become near orthodoxy in central banks, even some in the Fed itself question whether there is any empirical evidence. As one paper published by the Fed staff in 2021 began, “a review of the relevant theoretical and empirical literature suggests that this belief rests on extremely shaky foundations, and a case is made that adhering to it uncritically could easily lead to serious policy errors.” There is no indication that any of the current Federal governors share such concerns.
More troubling still is the danger that Bernanke warned of, namely that the arbitrary nature of the number and the need to remain flexible would be subsumed by the easy tendency of institutions to become rigid and dogmatic because that is easier than grappling with new and complicated scenarios.
As a result, there is no public indication that the Fed and its staff are seriously asking questions that it should. For instance, why not allow for wages to grow when all evidence over the past decade points to the continuing deflation of goods and services, first from the information technologies since 2000 and now and in the years ahead from artificial intelligence? Why not let inflation fluctuate in a wider band, not a much wider bad for sure but more than 2%, to allow for some organic settling of what is supposed to be a free market? Instead, the Fed seems so determined to achieve 2% that it is willing to hobble the labor market and crush wage growth to get there. To the surprise of many observers, both employment and wages have been resilient, but it’s not clear how much longer that can last in the face of such restrictive policies.
Today, there is little evidence that anyone at the Fed sees 2% as one possible target rather than the only possible target. There is little evidence that they would be willing to re-evaluate whether it remains the right target in a world that has changed since 2012, just as 2030 will look different than today. In reality, rather than in theory, there is no absolute right target, though presumably we could rule out double-digit inflation on one extreme and deflation on the other. But rather than treating 2% (or presumably any set number) as a moving target in a fluid world, the number appears to have become set in stone, an icon rather than a guide, an inflexible indifferent deity. When policy becomes dogma, watch out. Mistakes can be made based on faulty analysis and too little information, but nothing compares to the harm done in the name of dogma.
Leave a comment
