Time to rethink monetary policy? What is a "normal" economy?
In light of the increase in inflation that has happened for the better part of two years now, the strategy used by the Fed to manage it, known as inflation targeting, has come under scrutiny. The idea of inflation targeting is exactly what it sounds like. The Fed has, since 2012, officially had 2% inflation as its annual target. Under Jay Powell, that was slightly adjusted to what is called flexible average inflation targeting. Over a given period, measured in years, the average inflation rate should be 2%, which means it can be more than 2% percent some years if it is lower than 2% in other years.
This piece from Bloomberg argues that the era of 2% targeting and inflation targeting in general might be coming to a close. Inflation has been much higher than 2% and while it has come down from its peak it still is high and may remain that way for some time. Despite the Fed substantially raising interest rates for almost a year now, the job market has continued its hiring spree unabated. The author argues that if a “soft landing” is achieved, it will mark the end of inflation targeting. That is because the most likely scenario is inflation goes down, but not to 2% and everyone, including the Fed, learns to live with higher inflation even if nobody officially says so.
The 2% inflation target is not unique to the US. The first central bank to use it was in New Zealand. Other central banks soon followed. The target has not been without critics. Many economists have advocated for a higher target of 3% or even 4%. The goal is to give the Fed more flexibility in dealing with downturns by tolerating higher inflation and not getting sidetracked from helping the job market recover.
Abandoning the 2% target has come up some over the last two years. Powell has not changed that target nor would I expect him to at this point. With inflation still being much higher than 2%, if the Fed did abandon the 2% target now it would probably look like it had given up. That could have the effect of making inflation worse than it is now if people don’t think the Fed will even try to bring it down much more.
The question becomes what should happen if we have inflation around 3-4% and unemployment still remains low? Would it be worth taking the risk of raising unemployment and causing a recession just to get inflation back to its 2% target? Those who say yes base that on the idea of credibility. The Fed has to be trusted by everyone that it means what it says and will not give up, even if that entails a recession. If the Fed abandoned the 2% target now, it could lead to stagflation where inflation remains high and growth is low.
That may be right. It is entirely plausible that if people believe the Fed doesn’t have what it takes to stick to its target, then inflation will wind up being higher. If the new official target became 3%, then inflation could wind up being much higher than that because nobody will believe 3% is going to be adhered to when push comes to shove.
While I’m not anything close to an authority on monetary policy, I don’t think causing a recession to get inflation back to 2% from 3-4% is a good idea. Debates over the macroeconomy can quickly become very abstract. It is easy for those in positions of power and/or prestige to forget what happens when unemployment goes up and that is because that crowd never gets laid off. When unemployment goes up, millions of people lose their jobs and livelihoods. Businesses fail. People go through all kinds of hardships, both economic and social. If a recession is bad enough, entire regions can fall behind the rest of the country and wind up in a funk for years or decades.
Few things have made me more angry than hearing economists and others say that the only way to get inflation down is to throw millions out of work and anything else is impossible. For that crowd, it is as if the economy is just numbers, charts and graphs. I wonder how many of those advocating for a recession have ever been laid off or experienced any kind of hardship? Economists in particular tend to come from privileged backgrounds and are often the sons/daughters of economists. How many of those saying we need unemployment to go up would be willing to lead by example?
There is nothing sacred about having a 2% inflation target. The god of monetary policy didn’t come down from the heavens and decree that central bankers must adhere to it or he will flood the earth. It is a very recent idea and there is no reason it has to be treated like the ten commandments. If tolerating inflation higher than 2% is the price to pay for keeping this economy going, it is absolutely worth it.
As for the idea of Fed credibility, that is mostly speculative. I certainly don’t rule out that abandoning the 2% target could wind up making inflation worse down the road and maybe necessitating a big recession. That said, that is not knowable now. What is knowable is that a recession now means millions out of work. I will take the uncertain path that could be bad over the certain path that will be bad in a heartbeat.
Obviously, there are limits to how high inflation should go. Having it at 8-9% like it was for some of last year is not good. But having at it 3-4% is much more manageable. According to the Bloomberg piece, it is probably where we are headed anyway. If that is the case, I really don’t see why we should be throwing people out of work by the millions.
Are there risks to tolerating higher inflation? Absolutely. The attempt to target 2% inflation never really worked. The US and other countries that tried it consistently missed it. Until 2021, that meant they were undershooting inflation. Now, they are way overshooting it. The same could happen with a higher target. In aiming for 3% inflation, we could wind up getting inflation that is much higher and spirals out of control. The good news with a higher target is that if it is undershot, it is not as bad. For example, undershooting 3% and getting 2% is much better than undershooting 2% and getting closer to 1-1.5%, which is what happened last decade. By any measure, the jobs recovery last decade was sluggish and we should all hope to never repeat that again.
There is something very important about inflation to remember as it pertains to economic well-being. The biggest problem with the high inflation of the last two years has been that prices have gone up faster than incomes, making people worse off in real dollar terms. That is what needs to be avoided. If we have inflation at 3%, but incomes go up by 5%, that is a good thing. The goal in bringing inflation down is not to bring it down for its own sake, but to bring it down so that incomes are increasing in real dollar terms. Increasing incomes are how living standards get raised and human welfare is enhanced.
The Fed has had a dual mandate since the 1970s of trying to promote low unemployment and stable prices. It is a clear, but very broad mandate. Nothing is specified about what the inflation and unemployment rate should be. For the longest time, economists of almost all stripes assumed that there was a clear tradeoff between unemployment and inflation, known as the Phillips Curve. That has had plenty of validity in the past and likely still does today. But like every model, it was created by humans and is far from perfect.
One of the many reasons I approve of the job Powell has done is because he helped put a dent in the Phillips Curve. Traditionally, it was thought that there was a “natural rate” of unemployment. Part of that concept is the idea that there is a rate where if unemployment goes below it there will be an increase in inflation. There is not a solid consensus on what that rate is and it is never static, but it was generally thought that 4% was the rate where unemployment could not go below without causing inflation to go up. In 2019, unemployment was below 4% so according to that model, interest rates should have been raised to prevent inflation from going up. What did Powell do? He cut interest rates. What happened next was supposed to be impossible. Unemployment continued to go down and inflation didn’t go up.
At the end of the day, low inflation and low unemployment are what the Fed should be striving for. Accomplishing that is what counts. How it is done is not important no matter what someone’s model says.
There are obviously hardships that come from high inflation. We have seen plenty of that lately, which is why it needs to be brought down from where it is now. There are also hardships from unemployment, especially when it lasts for years. People can be thrown into poverty. They can lose their skills and become harder to employ in the future. It is not just those who lose their jobs who are harmed, but those who depend on them, too.
In the effort to keep the job market going, for now, I don’t think the 2% target should be abandoned. There is no point in doing that when inflation is still well above 2%. If we wind up in a situation where unemployment has gone up and inflation is still high, that will change the calculus regarding the necessity of a recession. At that point, it is likely millions will have lost their jobs and will be facing higher prices, too. The case for raising unemployment to bring down inflation will be stronger in that situation. But if we are facing the same or a similar level of unemployment like we are now, inflation is 3-4% and incomes are increasing at a higher rate, then we should be willing to live with higher inflation. At that point, the 2% target may not be formally abandoned, but for all intents and purposes it should be.
Having inflation at 3-4% might sound scary, but it shouldn’t. For the last 60 years, inflation has been at or close to that many times. There were plenty of times where it was in that range and people were very happy with the economy. It is important to remember how limited the data we have is when it comes to the macroeconomy and how little experience we really have with any kind of macroeconomic phenomena. Nobody knows what the future is going to look like with anything close to precision.
The Bloomberg piece says at the end that we may wind up having to abandon inflation targeting altogether because it is not workable. That may be the case. Given how so few economic ideas have proven to be timeless, that would probably be my assumption, too. Maybe a higher inflation target is used for a bit, but then abandoned or, as the author thinks is more likely, inflation targeting is abandoned altogether without the Fed formally saying so.
The author is not thrilled or scared of that prospect and that is how I feel, too. I have no idea what any future economic problems will look like. The only thing I know is that they will happen because they always do. Given that, in my view I think it is best to not adhere to any specific approaches for very long. What works for one set of problems isn’t guaranteed to work for a different set of problems. While leaving things up to discretion has its pitfalls, adhering to specific rules strikes me as a much bigger potential problem. The world is way too complex and unpredictable for any kind of hard set rules to work out well for long.
If inflation targeting is abandoned, it will require a rethinking of monetary policy altogether. What that would look like, I have no idea. There are alternative ways of conducting monetary policy besides inflation targeting. One approach is nominal GDP targeting, which does not look at inflation at all. Whether using that approach would be a good idea is way beyond my expertise, but it does have its adherents, many of whom I respect. That is just one alternative approach among many others.
For most of its existence, the Fed was a bystander in economic debates and only became a big player during the 1980s. As was mentioned earlier, inflation targeting is a very new thing and has only been official policy since 2012. What I am getting at is that abandoning inflation targeting need not be a problem. We survived before it and will survive after it. I think rethinking ideas of all sorts is a good and necessary thing.
There is no “normal” economy
It is common for people to talk about “normal” when discussing the economy. I think that is a misnomer. There really is no such thing as a “normal” economy. What we have are eras where different things are going on. Those eras can last for decades, but inevitably come to an end. Since the 1970s, we have seen a big increase in trade and globalization. Since the pandemic, that has begun to reverse some, especially with respect to the US and China. Ideas that were out of style from the 1970s onward, such as industrial policy and protectionism, now seem to be making a comeback.
With the caveat that I have no idea what the future holds, my guess is that the global economy going forward will look markedly different in some ways from what we saw from the 1970s until the end of last decade. US-China relations are as frosty as they’ve been in a long time and will probably remain so. Trade between the US and China will go down as the US tries to get its supply chains out of China. That will entail substantial government involvement in some sectors of the economy, especially for things like semiconductors. Ideas that were unthinkable not too long ago, like subsidizing entire industries, will become in vogue. In fact, some of those ideas already are being enacted, as the infrastructure bill, CHIPS Act and Inflation Reduction Act all involve spending that will boost certain industries and maybe create others.
The free trade consensus that had bipartisan support from Reagan through Obama is over and that is not coming back any time soon. There still will be plenty of trade going on, but the idea that more trade is always good is on an indefinite hiatus. There once was large, bipartisan support for trade with China, but now most seem to recognize that it had worse domestic economic consequences than previously thought and has not made China’s government any more accountable. As for the idea that no two countries that have McDonald’s have gone to war with each other, Russia and Ukraine both have McDonald’s. Free trade is not always the peacemaker its proponents have made it out to be.
How long this new era will last is anyone’s guess. For all anyone knows, it may last decades or it may be over in a short while. The dynamics will be different from what they were from the 1970s until 2020, just as they were different from the end of World War Two until the 1970s. That era saw manufacturing as the dominant employer while the era that came after it saw the service sector become the dominant employer, which is very much the case today. Each era has its own unique characteristics. That is not to say they are all totally different, but they each have their own features that make them stand out.
People get used to things when they go on for a while and forget about what things were like before. For example, until 2021 we had low, sometimes very low, inflation since the late 1980s. Last decade, inflation was very low as were interest rates and the tech sector thrived. Startups like Uber, Lyft and Airbnb took off and venture capital funding looked unlimited. People got used to it and acted as if that was how it would be forever. Today, all of that has reversed. There was nothing “normal” about anything from last decade. It was just an offshoot of bigger forces at play. Similarly, there is nothing “normal” about what is going on now. That, too, is an offshoot of bigger forces at play.
The rise and fall of the tech sector is one of many examples of things that look amazing for a while and then suddenly nobody wants anything to do with. It will thrive again, but nobody knows when that will be. The same is true for most everything else. Ideas that are popular today can go out of style and vice-versa. Things rise and fall in cycles. There is no “normal.” When someone refers to a previous period as being “normal” and talks about getting back to it, they are pining for a bygone era that is not coming back.