The Fed does a quiet about-face on inflation
The Federal Reserve has broken with its previous approach to monetary policy to an extent that few people realize.
When the Fed announced its new monetary policy strategy in August 2020, the announcement failed to make much news. The new strategy appeared to involve minor tweaks: Moving from an inflation target of 2 percent to an “average inflation target” of 2 percent, and switching from focusing on “shortfalls” from maximum employment to focusing on “deviations” from maximum employment.
Initially, it was unclear to most economists that these seemingly minor changes were obscuring a significant reorientation of Fed policy. Months, and many speeches by Fed Chair Jerome Powell and other members of the Fed’s Federal Open Committee later, it has become clear that, in fact, the Fed has effectively jettisoned the approach that had guided monetary policy since the Great Inflation of the 1970s. That approach was grounded in the theoretical contributions of Milton Friedman and Edmund Phelps in the late 1960s and the U.S. experience with high inflation rates during the 1970s. Friedman and Phelps argued that any attempt by the Fed to drive the unemployment rate below a certain minimal level — called the natural rate of unemployment — would cause the inflation rate to accelerate. A corollary of this view was that because a change in monetary policy takes more than a year to have its full effect on the economy, if the Fed waited until inflation had already increased it would be too late to keep the higher inflation rate from becoming embedded in interest rates and long-term labor and raw material contracts.
In a talk given in December 1967, Friedman predicted that without a change in monetary policy, the U.S. was headed toward a period of accelerating inflation. His prediction was accurate. Between 1950 and 1967, inflation had averaged less than 2 percent. From 1968 to 1982, it averaged more than 7 percent. At its peak, from 1979 to 1982, inflation averaged more than 11.5 percent. To bring these high inflation rates down, Fed Chair Paul Volcker forced up interest rates to record levels, triggering the severe recession of 1981-1982.
The hard-worn knowledge that once a higher inflation rate becomes embedded in the economy it can only be brought down by the Fed’s raising interest rates enough to cause a recession helped guide Fed policy until very recently. For instance, in 2015, then Fed Chair Janet Yellen noted that: “A substantial body of theory, informed by considerable historical evidence, suggests that inflation will eventually begin to rise as resource utilization continues to tighten. It is largely for this reason that a significant pickup in incoming readings on core inflation will not be a precondition for me to judge that an initial increase in the federal funds rate would be warranted.”
In other words, if the labor market is tightening, the Fed wouldn’t wait for inflation to reach its 2 percent target before raising the target for the federal funds rate. And, in fact, the Fed didn’t wait; it began raising the federal funds rate in December 2015 and continued doing so in several steps until December 2018.
But here’s Yellen, now Treasury secretary, in an interview last month: “We’ve had a very well anchored inflation expectations, and a Federal Reserve that’s learned about how to manage inflation. So, I don’t think it’s a significant risk and if [inflation] materializes, we’ll certainly monitor for it, but we have tools to address it.”
The Yellen of 2015 believed that once the inflation rate had increased significantly, the Fed’s using its tools — higher interest rates — to address it would cause a recession.
Or take Raphael Bostic, president of the Federal Reserve Bank of Atlanta. In 2018, he justified the Fed’s rate increases over the previous three years by noting that “… we shouldn’t forget that [the Fed’s] credibility [with respect to keeping inflation low] was hard won. Inflation expectations are reasonably stable for now, but we know little about how far the scales can tip before it is no longer so.”
His current view is quite different: [If] “it was clear that inflation was increasing above [2.5 percent] in a persistent and sustained way, then I think I’d have to really think about our policy stance and whether we need to react.” But by the previous Fed consensus, it will be too late to head off an inflationary spiral if the Fed responds only after the inflation rate has significantly increased.
There’s nothing wrong, of course, with Fed officials changing their minds as circumstances change. The puzzling aspect of current Fed policy is how quickly it changed and how reluctant Fed officials have been to admit the extent to which they’ve abandoned policies that had stood for decades.
Anthony O’Brien is a professor of economics, emeritus at Lehigh University.