Since we are constantly being bombarded with what the Fed may do this month or next, I thought it might be a good idea to look at some history on how we got to this place with a specific eye on the Fed’s 2% target inflation rate. Arguing in favor of a hike is the low unemployment rate, which fell to 5.1% in August. Arguing against it is the rate of inflation which, having come in at 0.3% year-on-year in July, is well below the 2% target that is the lodestar of Fed policy. But why does the Fed want 2% inflation in the first place?
Central banks are responsible for monetary policy which, roughly speaking, is the job of controlling the amount of money that courses through the economy. For a long time, monetary policy consisted of little more than stabilization of the exchange rate, which was often fixed (i.e. by the gold standard at the beginning of the 20th century) to facilitate international commerce. But exchange rates proved a poor target for policymakers. Pulling money out of the economy to buoy the currency and protect the exchange rate could send the economy into a tailspin; such policies helped create the Great Depression of the 1930s.
After the Great Depression, governments also added domestic employment to their list of priorities. Central banks reckoned the economy followed a relationship known as the Phillips Curve, which proposes a trade-off between inflation and unemployment; governments could have less of one if they were prepared to accept more of the other. Yet, amid the “stagflation” of the 1970s which was an unholy mixture of economic stagnation, including high unemployment, with inflation, economists realized that the relationship between inflation and unemployment weakened over time, as people figured out what was going on and revised their expectations for future inflation. The stimulative effect of faster price growth faded, leaving economies with both high inflation and high unemployment. Economists realized the best a central bank could do to boost long-run growth was to make the path of policy clear and predictable to the public – to be more “transparent”. I’m wondering if anything has been clear and predictable in the past few years in regards to our central bank, the Federal Reserve?
Anyhow, to increase transparency, central banks needed to select an economic variable to use as a target: one linked to the health of the economy and over which the central bank could exercise some control. A clear, public target would keep central banks disciplined and help stabilize the economy (markets would anticipate easier policy when the economy looked like it was falling short of the target, for instance, and increased spending and investment would, therefore, help the central bank push the economy back on the right course). Milton Friedman, a Nobel prize-winning economist, reckoned central banks should aim for growth in the money supply. Central banks tried that for a while but found that when they made money growth their target, the relationship between it and the health of the economy broke down just as using the Phillips Curve model had. Many policymakers then settled on using an inflation target. Inflation was readily observable and, it was thought, was a reliable thermostat for an economy. The central bank of New Zealand was the first to adopt an inflation target, in 1990. The Fed pursued an unofficial inflation target over a long period, only making its policy official in January 2012 when it announced that a policy targeting a 2% rate of inflation “is most consistent over the longer run with the Federal Reserve’s statutory mandate.”
Why 2%? A higher inflation rate is costlier in economic terms than a lower one. Higher inflation is often more volatile, and since some prices adjust more easily than others, a higher inflation rate can generate distortions in the economy as relative prices fall off-kilter. But low inflation is not without its risks either. With low inflation, firms can find it hard to cut wages, in many cases. But if inflation is high, then the real cost of labor can fall even if actual wages don’t (because workers become cheaper relative to the goods they are producing), so firms face less pressure to lay-off workers in a downturn. Moreover, a lower inflation rate corresponds to lower interest rates (since creditors demand an inflation premium when lending over longer periods of time).
When interest rates are very low, odds increase that a central bank might have to reduce its benchmark interest rate all the way to zero to fend off economic weakness. Since central banks can’t easily reduce their interest rates below zero, low inflation effectively boosts the chances that a central bank will become relatively helpless in the face of a nasty recession.
In the early 1990s, when many central banks were deciding what rate to pick as their target, it was assumed that this “zero lower bound” would only rarely become a problem at a 2% rate of inflation. That judgment, as it turns out, was wrong. Just a few decades later, most of the wealthy, developed economies in the world are stuck with interest rates near zero, and with inflation rates well below official targets. Whatever the Fed decides to do over the next month or two, it appears that central banks may need to change their targets once again, and soon.
Another issue involves how inflation is calculated in the first place. Most indices are measured as the price of a “bundle” of goods and services that a representative group buys or earns. Over time the bundle changes. For example, carriages are replaced with automobiles, and new goods and services, like cell phones and heart transplants, become inputs. So as the so-called “basket of goods” changes over time, is it really even fair to compare the basket’s contents from one period of time to the next? Furthermore, there is no single “correct” measure, and economic historians use one or more different indicators depending on the context of the question. Indicators used today still include CPI, GDP Deflator, Consumer Bundle, Unskilled Wage, Compensation of Production Workers, and a few others.
It’s quite possible the bottom line comes down to trying to establish a target rate in an economic environment that is rapidly changing. One that is being measured by methods that are consistently being revised, and with a basket of goods that is different today than it was just a few, short years ago. It may prove to be quite the problem.