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Outside the Box: Inflation needs to get back to 2%, but the Fed won’t do what it takes. We’re paying a high price — literally.

Ever since U.S. inflation began to go wild, we have existed in an environment that in many ways hasn’t make any sense.

In the first place the Federal Reserve had promised that it would corral inflation around the 2% mark, and then it failed to do that. After having a period from 2012, when it adopted targeting, through 2019 when inflation consistently but mildly undershot its target, the Fed changed its objective to allow inflation to run a little bit hot relative to its 2% target and then strangely, it promised forbearance on raising rates until the economy had achieved full employment.

These changes represented heresy with respect to the monetary rules that were the backbone of good monetary policy.   

Bad to the bone

These were changes in the Fed’s operating procedures that many economists were opposed to and that, at the time, didn’t make a lot of sense. In retrospect, upon greater reflection, they make no sense whatsoever.

These are the rule changes behind the Fed’s decision to allow inflation to run hot and to not oppose it. As inflation ran high, in 2021 the Fed was in denial. It was under pressure from progressives to be “less preemptive.”

Plus, Chair Jerome Powell’s term was ending and he wanted to be reappointed. So he very well couldn’t buck the progressives. The Fed called inflation “temporary.” Eventually the Fed agreed that it was not temporary. But even then, it took its time, waiting almost a year from the time inflation went up above 2% until it began raising the federal funds rate by even one basis point. 

Once the Fed began to raise rates, Powell misspoke, calling the Fed funds rate at 2.5% “neutral.” This was at a time when you couldn’t possibly see the federal funds rate as neutral since it was still so far below the inflation rate. Former U.S. Treasury Secretary Larry Summers blasted Powell for that statement.  Even now, the fed funds rate is short of being restrictive: it’s still accommodative, and not neutral. But this misstep is typical of odd views we continually see and that are priced into markets asserting that inflation, high as it is, will apparently heal itself.   

An ongoing policy blunder

When the Fed was considering making changes to its operating procedures, particularly as it formed a new framework agreement, it went around the country with a program called “The Fed Listens.” It entertained notions of changing its inflation target. In the end it did not. Currently there are a few op-ed pieces being written by well-known market players and economists saying that it’s too late for the Fed to change its inflation target. Mohamed El-Erian is one of them. Ken Rogoff, a former Fed economist, is another. I find such statements to be quite strange. They exist in isolation, in an environment where no one is questioning whether it’s appropriate to change the Fed’s inflation targets or not.  What does it mean to say it’s too late to change something that should not be changed anyway?  

Price stability

If we go to the Fed’s greatest inflation fighter of all time, former Chair Paul Volcker, we find that he wondered whether a 2% U.S. inflation target was low enough. Let me repeat that: “low enough.” Enter the pretenders. Several Nobel Laureates including Peter Diamond, the labor economist, and Joseph Stiglitz have endorsed a U.S. inflation rate of 3% or 4%. Yet they avoid addressing whether this is consistent with the Fed’s mandate for price stability.

These higher inflation suggestions have largely come from economists who would be extremely concerned if the U.S. unemployment rate was not at the full employment mark. However, they seem to have no problem wanting to shift to a “price target” that could hardly be construed as price stability, even though that goal must be viewed as the most important of all the central bank’s goals. The U.S. central bank has been given two charges: (1) to achieve maximum sustainable employment and (2) price stability. 

Elsewhere in the world, central banks have only the goal of price stability. That’s what the central bank can achieve. Central banks really are not able to deliver full employment.  Nonetheless, it’s a charge that’s been given to the Fed and the Fed must take it seriously.

Playing the percentages

There’s something known as the “Rule of 70” that is a simple algorithm for vetting different inflation rates. You take an inflation rate and divide it into 70, and what results is an estimate of the number of years that inflation rate would take to double the price level. 

With 2% inflation, for example, prices are going to double every 35 years. Given average life expectancy, it means that prices are going to double twice in your lifetime. Is that price stability? 

This is something Volcker worried about. Of course, if the inflation target went up to 4%, prices would double over 17 ½ years, or four times in a lifetime.  It’s hard to understand how anyone could construe that as price stability.

Achieving the 2% target is going to be somewhat painful. Both the Fed and the markets have been trying to convince us that the U.S. inflation rate is going to go down all by itself and there will be little or no pain associated with this. But as time goes on, we’re beginning to see that the inflation rate is not simply going back down to where it was (note the recent CPI and PPI). The inflation rate is coming down all right, but the world has changed and that inflation is not going to get down to 2% without some considerable effort by the central bank. It’s probably going to involve the kind of effort that’s going to get in the way of creating full employment.

This is the problem with the Fed now interpreting full employment as a short-term policy mandate, instead of as a broad goal, which used to be the case. Prior to all this recent nonsense, the Fed, under Volcker and later Alan Greenspan, used to argue that when the Fed delivered price stability it made its contribution to achieving full employment. Viola: two goals in one policy equals the end of policy tension.

Price stability did create the best environment for achieving full employment. But the Fed under Powell has abandoned that approach. It acts now as though it no longer has an inflation mandate (which, of course, it isn’t achieving) and as though it has a short-term mandate to keep the unemployment rate at full employment. Of course, it is impossible for the central bank to do both of these things at the same time.

How much inflation does the economy need?

As far as I know no one has produced a paper or proof indicating that 2% or lower is a necessary level for inflation to achieve price stability, although common sense brings you to that conclusion. Two percent inflation as price stability already requires taking some license with the term “price stability.” Because this isn’t price stability. It certainly isn’t price level stability. It is inflation stability, but of course you could have inflation stability at 10% or 20% as well. The Fed actually targets inflation stability but at a reasonably low inflation rate, and that is a judgment call.

Frankly, it’s simply harder to imagine that anything above 2% could be deemed price stability, and that’s the problem. It’s also true that other countries around the world with inflation targets have chosen 2% as the target. If the U.S. were to choose a different number, it would be out of step internationally.

The most important thing we need to do is come to terms with the fix that we’re in. We must realize it is going to take some doing to return inflation to the 2% mark, and just because it will be difficult doesn’t mean that the Fed shouldn’t do it. “Take some doing” refers to either (1) raising rates much higher to reduce inflation to target sooner, or (2) keeping rates higher for longer to squeeze inflation back to the 2% mark. 

But no advocate of slower Fed rate hikes will admit this. There is an unspoken conspiracy to pretend that we can get the timing of case (1) with the policy of case (2).

All I can say is, that’s not being transparent. 

Robert Brusca is chief economist at FAO Economics.

Read more: The Fed expects a ‘soft landing’ and no recession for the economy. We could get stagflation instead.

Plus: The Federal Reserve lost its way in the fight against inflation. This is how it can get back its credibility.

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