Prognosis poor for the Fed’s 2 percent target
Readers of a certain age (OK, boomer) will recall the long-running demise of Spanish dictator Francisco Franco and its satirization by “Saturday Night Live.” After a 40-year rule, General Franco fell into a three-week coma before passing away in November 1975. Seemingly breathless news reports in the U.S. of his obviously hopeless struggle for life were so repetitive that they became a skit in the first year of “SNL” with continuing lines for years afterwards that “Generalissimo Francisco Franco is still dead.”
One of the Federal Reserve’s principal goals, its 2 percent inflation target, is in a similar condition. 2019 has seen inflation, measured with the Fed’s preferred gauge of core personal consumption expenditure (PCE) prices excluding food and energy, around its level through November of 1.6 percent. Since the Fed announced the 2 percent target in 2012, its record has been perfect; it has never achieved the goal for a calendar year, zero for eight. In fact, going back to 1996, there have been only four years when inflation exceeded this target, 2004 to 2007. (Think about what happened during those pre-financial crisis years.)
Missing the inflation goal appears to have little actual consequence for the U.S. economy, which obviously is healthy with record low unemployment and growth around its potential. One could say a few tenths of a percent is good enough for government work, and the Fed is part of the government. Indeed, according to San Francisco Fed research, the Fed’s leaders used to have a 1.5 percent target before the crisis. It was typical to describe an inflation objective between 1 and 2 percent, in which case the current inflation level would be absolutely fine.
Current Fed leaders are more rigid. New York Fed President John Williams says that the Fed must stick to its 2 percent goal. Federal Reserve Board Vice Chairman Richard Clarida says, “We . . . take as given that a 2 percent rate of inflation . . . is the operational goal most consistent with our price-stability mandate.”
It’s often the “givens,” the unexamined assumptions, that trip us up, and the Fed has never explained why 2 percent is superior to 1.5 percent or a range around it. The origin of the 2 percent figure comes either from New Zealand, where the central bank originated inflation targeting in 1989, or from noted Stanford economist John Taylor, whose Taylor Rule in 1993 mentioned a hypothetical 2 percent inflation target.
Nothing says current U.S. economic conditions are comparable to those in New Zealand in 1989, which at the time was fighting high inflation, or even to the U.S. itself in 1993, with population and economic growth nearly twice current levels. The Fed must justify why 2 percent is appropriate for the U.S. now.
If the Fed can describe, for the first time, why 2 percent is the optimal U.S. target, it can then address how, after a generation of failure, it actually plans to get there. Not only has the Fed been unable to hit its target on a sustained basis, but so have other major central banks, the European Central Bank and the Bank of Japan. All three have poured massive resources into inflating their economies, from 20 percent of GDP in the U.S. to 100 percent in Japan, yet none have reached their targets. Why would the Fed now suddenly succeed?
To this end, the Fed has embarked upon a “Review of Monetary Policy Strategy, Tools, and Communications” to reorient policy to finally hit its target. The Fed, and most monetary economists, believe in an expectations theory that inflation is determined by what participants in an economy expect inflation will be. As part of its review, the Fed may change the basis of its inflation target to a long-term average inflation rate or to a price level that reflects a long-term average rate.
This begs the essential Catch-22 question of inflation expectations theory. On the one hand, as New York Fed President Williams stated, “the history of inflation plays a big role in inflation expectations” — we need higher inflation to boost expectations. On the other hand, we need higher expectations to boost inflation. How will the Fed’s new strategy resolve this dilemma?
It’s not even clear the economy pays attention to the Fed’s inflation goal. While the Fed has elegant mathematical models incorporating this theory, right now in the bond market a combination of inflation-adjusted and regular U.S. Treasury bonds produces a breakeven rate for expected future inflation for 30 years around 1.80 percent for Consumer Price Index inflation, which translates to about 1.55 percent for the Fed’s core PCE measure. The financial markets, which pay very close attention to the Fed, seem to utterly disregard its 2 percent target for the next 30 years.
All this might be of merely passing interest with the economy performing well. But the Fed is insisting not only on reaching 2 percent inflation but on surpassing it. Fed Chairman Jerome Powell has repeatedly called for a “symmetric” target with inflation sometimes above 2 percent.
The one precedent for this is the mid-2000’s that entailed an increase in private debt of 50 percent of GDP and a one-third decline in the foreign exchange value of the dollar. Here’s another Catch-22 for the Fed — the economy’s good when it doesn’t hit its target, but we have a financial crisis when it does. What reason is there to believe next time will be different, that, to boost inflation over 2 percent, we won’t need a massive debt increase and depreciation of the dollar?
Maintaining flexibility to respond to economic downturns is the principal reason the Fed seeks higher inflation. It wants latitude to cut interest rates. Former Fed Chairman Ben Bernanke’s analysis is that the Fed has stimulative tools to adjust to interest rates as low as 2 percent. Most recessions are preceded by rising inflation, so in today’s low inflation world, they may be less frequent, as has been true for the last two recoveries. Ironically, a recession and financial crisis may be more likely if the Fed actually attains its 2 percent target than if it doesn’t.
So, for its strategic review, the Fed must explain to Congress, the financial markets and the public why its inflation target matters beyond its sophisticated models, why it should be 2 percent, how it can accomplish this and how it can avoid past problems with higher inflation. Otherwise there may be many more refrains of: “The Federal Reserve failed to hit its target (and Generalissimo Franco is still dead).”
Douglas Carr is a financial markets and macroeconomics researcher. He has been a think tank fellow, professor, executive and investment banker.