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Fixating on Credibility Rather Than Following the Data Discredits the Fed

After more than a year of aggressive rate hikes, the Federal Reserve has now held them steady after each of the past two Federal Open Market Committee meetings. After peaking at levels not seen in decades, inflation has leveled off in the three-to-four percent range for months now. On top of that, job openings, and consumption all seem to have slowed notably. All of this adds new context to the debate between proponents and opponents of Fed hawkishness. 

When elevated inflation first became a serious concern following macroeconomic shocks—from a global pandemic, huge recession fighting policy, and (later) the Russian invasion of Ukraine—economists and pundits quickly split into two broad camps on what was happening. On the one side, there were those who saw high inflation as a passing issue due to serious disruptions caused by giant exogenous shocks. That group, dubbed “team transitory,” believed that this bout of inflation was not due to overstimulation of the economy. On the other side were those who insisted inflation was being driven by the demand side; they argued that the fiscal stimulus had been too large, and that the job market in the recovery was too strong. That view relied on the idea that prices were responding to elevated demand from excess savings, rather than price shocks in the supply chain or corporate price manipulation. 

In retrospect, the evidence shows that team transitory was right (although additional shocks to the macroeconomy kept inflation high longer than most of them predicted). And yet, despite the mounting evidence and the early signs of economic cooling, the Fed has not reversed course. A big part of why is a compulsion to try and get inflation to two percent. But that fixation now poses a serious threat to our economic well being.

Back at the start of this year, I wrote a piece covering the Federal Reserve’s two percent inflation target and why taking it as gospel is misguided. Since then, there has been considerable discussion about whether the target rate should be changed, with the case for abandoning two percent made in The Financial Times last spring by Columbia University’s Adam Tooze. Following that, the FT published a letter to the editor arguing against Tooze’s point, Harvard economist Jason Furman agreed that it was worth reconsidering, and former Treasury Secretary (and sleazy fintech businessman) Larry Summers thoroughly dissented.

As Nobel Laureate Paul Krugman has written, the primary concern about easing the two percent target revolves around nebulous fretting about the credibility of the Fed. As he put it, proponents “fear that if they ease off at, say, 3 percent inflation, markets and the public will wonder whether they will eventually accept 4 percent, then 5 percent and so on.” Such concerns seem rather oblivious to the Fed’s extremely strong (potentially too strong) inflation-fighting strategy. Surely, they’ve built up enough of an inflation hawk reputation that they can take a slight hit. Moreover, despite inflation running slightly high still, financial markets seem at ease with the current level and inflation expectations have remained anchored. All of this makes warnings of a loss of faith in the Fed seem like a bit of a reach.

Before we get into the weeds, it’s worth explaining the origins of the two percent figure. What’s the importance of that specific figure? As I wrote, “the target is more tradition than science.“ The exact figure originated from a television interview with the New Zealand Finance Minister in the 1980s. At the time, New Zealand was experiencing serious inflation, nearly ten percent, and the government wanted to give the central bank a codified target. Since then, two percent as a target has become the norm among rich countries. However, not every central bank that uses it as a baseline clings to it as aggressively as the Fed; a number of them, including the Bank of Canada and the Reserve Bank of Australia, use a more flexible version of the target. In Canada, the target is two percent plus or minus one percent. In Australia, it’s two to three percent. A quick glance shows that such ranges are not at all unusual. Until relatively recently, the Fed’s target was similarly flexible by de facto. 

Indeed, the exact figure was only officially adopted by the Fed under then-Chair Ben Bernanke in 2012 (though it had been tacitly endorsed since 1996). In the 1990s, future Fed Chair Janet Yellen was among those who pushed for a higher target rate to allow more discretion on the Fed’s part and guard against deflation. 

Additionally, as Krugman has explained, two percent also became typical because it functioned as something of a compromise between economists who wanted absolute price stability (a zero percent inflation target) and those who wanted positive rates to give central banks more room to fight recessions by allowing for a lower real interest rate. 

There are arguments about why such a target is good, but practically none of them are specific to two percent. Because inflation measurements tend to skew higher than the true level, it can be important to have a positive target even if the goal is to have functionally no inflation. Certainly, in order to have stable prices, we must have a target that’s relatively low. But that explains why two percent is preferable to, say, ten percent, not why it’s any better than slightly higher inflation. In fact, work by scholars at the University of Massachusetts shows that three to four percent levels don’t constrain growth and can be conducive to stronger economic performance than inflation of two percent.

There is a very good reason, however, why the target needs to be a low positive number. If the target is zero percent or lower, then there is a higher risk of deflation, where people’s money becomes more valuable, which can trigger a recession because the return generated by parking assets deters people and firms from spending and investing, instead opting to sit on their money. This then tanks the “velocity” of money, an econ term for how freely money circulates in the economy; a healthy economy needs money to be moving.

A positive target also allows for monetary policy to better fight recessions. While theoretically possible, banks (including central banks) don’t offer nominal negative interest rates. If they were to, no one would keep their money there (which in turn means they wouldn’t really be impacted by rate changes) unless they were forced to. What central banks can do is create negative real interest rates, but only if inflation is more than zero. (Real interest rates are equal to nominal rates minus the inflation rate.)

On the other hand, there are reasons why holding on tightly to two percent is bad policy. To start, it commits the Fed to prioritizing aggressive inflation fighting over the other half of its mandate: maintaining full employment. Committing to such a low target and refusing to reevaluate is a promise to sacrifice jobs in order to reach such a low level of inflation. Particularly given that there is no strong empirical evidence that two percent is hugely preferable to three or four percent, there is no reason for the Fed to be creating conflict between its dual mandates that otherwise need not exist. This is further exacerbated by the de-linking of employment and inflation captured in the Phillips Curve. In the United States, the relationship simply does not hold. As a result, higher rates from the Fed can force investment and employment down, but without making a dent in inflation.

The obvious counter to such an argument is that the rate hikes haven’t triggered a recession, spiked unemployment, or seriously undermined investment. To the extent that this is true, that can, in itself, be a reason to stop relying on high interest rates to lower inflation; employment is the mechanism by which rate hikes would be expected to influence inflation. The fact that inflation fell without a recession or mass unemployment clearly demonstrates that keeping rates high in pursuit of a two percent target is misguided.

Remember, also, that when the rate hikes started the economy was very strong. And new job openings have fallen since then. Given the significant lag between rate changes and observable macroeconomic adjustments, it’s entirely possible that we are heading in that direction and it’s just taking a while. Regardless, maintaining high rates that risk undermining the labor market and the broader economy still isn’t worth it when it isn’t achieving any meaningful policy goals.

Additionally, given the trend of Secular Stagnation, there’s reason to believe that slightly higher inflation is necessary in order to fight future recessions without hitting the zero lower bound. In an economy with secular stagnation, negative real interest rates become more important because nominal interest rates will stay low most of the time to encourage investment rather than savings. Ironically, this theory was popularized by Larry Summers, who is now one of the champions of inane defenses of central banking as usual. 

And, as Adam Tooze pointed out, higher interest rates being deployed to push inflation down can also stress banks and depress developing economies. The Fed’s elevated interest rates create a higher cost of borrowing, undermining banks’ ability to cover any current shortfalls. As the mantra goes, banks borrow short and lend long. All fixed-rate loans that they made before the rate hikes can be locked into a lower rate than the bank can borrow at, meaning they lose more in interest payments than they earn. And if there’s a bank collapse, that can easily spark a financial crisis and lead to a recession.

Developing countries, meanwhile, are going to get loans on much worse terms—that might be difficult to pay off—while rates are high. That in turn could undermine their ability to build out infrastructure and new industries, causing lost income. In all, this means gains from global trade will be lower than they could be, keeping poverty, underdevelopment, and global inequality worse than they might otherwise be.

So why is the Fed’s credibility, rather than resting on good policy, tied intimately to a target of two percent? Former investment banker Stephen King wrote in response to Tooze, “choosing to raise targets when inflation has persistently surprised on the upside smacks of no more than short-run political opportunism.” Similarly, Summers wrote that:

…the chairman needs to respond explicitly or implicitly to the growing chorus suggesting that the Fed should adjust its inflation target. For years, the Fed has been firm in its commitment to 2 percent. Of course, there are legitimate academic arguments about the merits of having a numerical target and, if so, what it should be. But timing and context are crucial.

But their argument runs counter to what is supposed to be the bedrock of Fed credibility: a commitment to following the data. Although both King and Summers concede that there are good academic arguments for changing the target, they argue that now is not the time. But the opposite is true—changing the target now is ideal because it would epitomize the Fed’s commitment to following the evidence and maintaining its dual mandate. All of the best available evidence shows that monetary policy cannot possibly be responsible for disinflation. The only theoretical mechanism for it to have done so would be via the employment rate, which remains strong.

To continue to obsess over two percent simply commits Powell to a course of action that will betray half of the Fed’s mandate and runs counter to the best evidence available. No one seriously advocating a change is calling for a hairpin U-turn. Indeed, they can even follow Furman’s step-by-step guide on how to properly change course

Additionally, there are reasons why abandoning or altering the two percent target very soon is appropriate, beyond the general issues outlined above. For one, the harm of a recession right now would likely be worse for ordinary people because of the extremely high interest rates. If a recession were to begin before the Fed starts lowering rates, then the job loss and decreased economic mobility that comes with it would also be paired with a very high cost to borrow. That means that people who don’t have significant savings and lose their jobs will find it more costly to use credit cards, personal loans, or home equity to fill the gap until they find work. 

On top of that the high interest rates are a barrier to people buying houses, which has multiple downstream impacts. To start, it has locked many out of using a home to build equity, which is one of the biggest forms of wealth building in the American economy (and eliminates one possible form of borrowing for a lot of folks). It also forces more people to live in rental properties, which see rent increases because of additional demand (plus rent is already high because of residential price fixing). To round things out, it hurts people who already have homes as well. High rates can make it prohibitively expensive for people with houses they own to move, even if they would have more opportunities somewhere else. Between getting less money from selling their home and extreme mortgage interest rates, moving would probably mean either lowering their standard of living or becoming a renter, unless they moved to somewhere with a much lower cost of living.

The Fed has even seemingly acknowledged that the target is less than ideal; they frame the target as a long term average of two percent inflation. But that doesn’t actually increase flexibility because it only enables them to ease inflation fighting in the present to the extent that they’re confident that inflation will be below two percent in the future to average things out. A much better and simpler solution would be to revise the target upwards to three percent or create a range of two percent plus or minus one percent, either of which would no longer call for elevated interest rates and both of which have international precedents.

When Paul Volcker’s war on inflation ended not quite half a century ago, the inflation level was still four percent. And the following Reagan years are remembered for a robust economy featuring a historic presidential re-election. The hyperfixation on getting down to two percent accomplishes little—well, unless returning Trump to office is one of Powell’s goals—and risks a whole lot. It exposes banks to huge interest rate risk, makes it harder for developing countries to build themselves up, limits housing options, makes people more vulnerable if a recession does come, and creates an ever-present threat of causing mass unemployment or major cuts to economic investment. Meanwhile, virtually all of the good parts of the target will still apply—some even more so—with a slightly higher or more flexible target.

Dylan Gyauch-Lewis is a researcher at the Revolving Door Project.

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