What on earth could transform an obscure number that few knew or cared about into a force that, if you believed the news accounts, threatened the global economy as well as our own?
That question, or one like it, must have prompted the authors of a recent research paper on the subject. The Federal Reserve Bank of San Francisco has just released a working paper, “The Evolution of the FOMC’s Explicit Inflation Target.” The FOMC is the Federal Open Market Committee, which is tasked by statute with responsibility for the Fed’s dealings with the financial markets to affect interest rates.
That might seem like a musty academic subject and it was, until recently. Now, though, the same, once-obscure inflation target is at the heart of of today’s headlines. It is the engine powering the Federal Reserve’s monetary policy, President Donald Trump’s tweets criticizing the Fed and the news media’s moaning about central bank independence. The working paper couldn’t have come at a better time.
Like so many economic issues of our times, the controversy over the inflation target, and over our monetary policy in general, has been somewhat exaggerated in the news media.
There is no real effort, for example, by Trump to rein in the independence of the Federal Reserve, our central bank. He is openly in disagreement with its current policy and believes that lower interest rates would spur our economy’s growth. He is not alone in that view. And, more importantly, the U.S. Treasury, the financial arm of the president, continues to work closely with the Fed to ensure stable financial markets. That does not seem like part of a determined presidential assault on the Federal Reserve’s independence.
In our economy’s history we have had times when the Treasury and the Fed were openly working at cross purposes — creating a “push-me-pull-you” economy. It was not seen as a threat to Fed independence, though. The value of an independent Fed as an institution was and is too high to be dissipated in a transient policy disagreement.
Even without politics, our economic situation is puzzling enough. We are in uncharted territory. The relationship between unemployment and price inflation — portrayed in what is known as the Philips Curve — isn’t behaving itself. It is no longer a solid predictor or working the way it used to. Over the past two years, for example, we have had remarkable economic growth and record low unemployment … but not the runaway inflation that these two factors normally bring with them when they march together.
Before January 2012 when one was announced to the public there had been no explicit inflation target at the Fed. Promoting “stable prices” had sufficed as a goal for the previous 99 years.
If the Federal Reserve had managed to function without an explicit inflation target for 99 years, why did it suddenly need one in 2012?
There are two reasons, both understandable. The first is that in January 2012, the Federal Reserve was the only financial institution still standing intact after the Wall Street crash and subsequent recession. Our economy had taken up lodgings in the doldrums, and Congress, the financial markets and the general public were looking to the Fed to “do something” — since it was the only one that could. Publicly setting an inflation target signaled that the Fed would accept some inflation as the price of economic growth and recovery and would keep interest rates low.
The second reason was that announcing the target advanced the idea of “transparency” and reduced the not uncommon belief that the Fed was a secret organization. The truth is that the Fed has few secrets and its monthly financial statements reflect its market moves and reveal its policies very accurately.
Announcing specific targets achieved little except to further roil financial markets that were already obsessed with gaining an edge on Fed policy. If anything, it added volatility to the financial markets and magnified the casino atmosphere that still hovers above Wall Street.
The working paper from the researchers at the San Francisco Federal Reserve gives us a useful perspective on the explicit inflation target, and a first step toward evaluating its usefulness.
In the evaluation we should consider that the Fed’s ability to manage interest rates to the quarter point and less masks the fact that it is really more of a blunt instrument than a precision surgical instrument. In order to use interest rates to lower a Consumer Price Index increase driven by oil prices, for example, we would have to slow down the entire economy.
The bottom line is that we should reconsider whether a publicly announced goal of a specific inflation rate serves any good purpose or was a mistake that should be corrected.
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