The Federal Reserve is widely expected to keep interest rates unchanged at its policy meeting next week, shifting the market’s focus to signals about what comes next. Yet, behind the scenes, something far more consequential to the wellbeing of the US is playing out: A review of the Fed’s monetary policy framework.
This appraisal of the central bank’s communication, strategy and policy tools was initiated last year and is expected to conclude in August. It aims to ensure that the Fed’s actions and words are effective in delivering its dual mandate of maximum employment and price stability.
A similar review in 2020 proved largely irrelevant as its “longer-term goals and monetary policy strategy” were overtaken by events such as the global pandemic and self-created challenges, too. This time around, the rigidity with which a certain parameter of the review has been defined risks straitjacketing the Fed.
The Fed needs to learn from experience as well as internalize unprecedented changes in the economic landscape. In addition to significant ongoing structural changes both domestically and globally, the administration of President Donald Trump is expected by some to upend the existing order and fundamentally shift the operating paradigm for companies, governments and central banks. Yet, from the outset, the Fed has insisted that the way it defines price stability is, to use Chair Jerome Powell’s words, “not on the table.”
At first glance, this makes sense. The current 2% inflation target is common to many central banks including the Bank of England and the European Central Bank. Since its birth in New Zealand’s inflation-targeting experiment of the early 1990s, it has served modern central banking well. Moreover, being arbitrary in its formulation, there is no agreed-upon analytical approach to specifying an alternative.
Yet the operational context has changed radically. Most fundamentally, the world is no longer subject to the multi-decade series of positive supply shocks that resulted from China’s entry into the global economy and the collapse of the Soviet Union. In the last few years, economies around the world have faced more frequent and violent negative supply shocks. Looking ahead, this trend is intensifying.
By rejecting any analysis of whether the 2% target remains appropriate, the Fed risks finding itself in a position similar to the UK government. In the run-up to the July election, the Labour Party ruled out any increases in income tax and value added tax. This miscalculation robbed Prime Minister Keir Starmer’s government of the flexibility it needed to address, in a pro-growth manner, the fiscal challenges it inherited. The first set of major budget announcements last October overburdened a single revenue source, national insurance contributions. The next set, due later this month, may try to excessively reduce welfare spending.
Like the British government, the Fed may find itself overly constrained by its current inflation target and, inadvertently, risking collateral damage and unintended consequences. Unlike the UK government, however, the Fed does not have the tools to go “further and faster” — as Chancellor Rachel Reeves has promised — and seek to structurally improve growth through infrastructure investment, planning reform and de-regulation. The Fed’s tools do not directly impact productivity.
I have received two main objections to my suggestion that the Fed should have a more open mind on its inflation target.
First, revising the target would harm the central bank’s credibility at a time when it has consistently overshot its existing target for almost four years. It could un-anchor inflation expectations and erode the effectiveness of policy tools.
Second, the Fed has, in practice, already been flexible about its target. If this were not the case, the current inflation situation would fuel widespread market speculation on the timing of the next rate hike rather than the next cut.
Both pushbacks are reasonable, but they are not deterministic.
On credibility, the political risk to Fed independence and the harm to the economy could be much bigger if the central bank were to pursue overly tight policies that repeatedly undermine maximum employment. As to the Fed’s option to say one thing and do another, it wouldn’t surprise me if that is already the case. The problem is that this only works long-term if it’s a bridge to a more sustainable position, and I question the appropriateness and viability of a 2% target in our structurally changing world.
Those who have known me throughout my academic and professional career may be surprised to hear me arguing for the Fed to be open minded about the possibility of a higher inflation target. Specifically, a 0.5 percentage point band with the bottom end slightly above 2%, at about 2.25% or 2.50%. I strongly suspect this is where a “first principles analysis” of the most appropriate inflation target would end up. Such a change could be implemented in a manner that minimizes possible disruptions.
The bottom line is simple. The world’s pre-eminent central bank must have the potential to act as a durable bulwark of price and financial stability and a purveyor of maximum employment and lasting economic well-being. To preempt any internal review of its inflation target is imprudent. It risks more than unduly damaging jobs and incomes. It can also inadvertently result in an erosion of the Fed’s institutional credibility and political autonomy.
A message from Advisor Perspectives and VettaFi: To learn more about this and other topics, check out some of our webcasts.
Bloomberg News provided this article. For more articles like this please visit
bloomberg.com.
More Asian/European Markets Topics >
