The Fed's 2018 New Year's Resolution

In February Jerome Powell takes over as chair of the Federal Reserve, succeeding Janet Yellen. His first order of business should be to get the Fed off its silly, outdated and nonsensical monetary policy target of 2% inflation. He and the other members of the Federal Open Market Committee should at the very least change the inflation target number, or, better yet, find a different measuring stick altogether.

One of the Fed’s mandates, we know, is to keep inflation “stable,” as noted on the Fed’s website, citing the Federal Reserve Act (the other two mandates are achieving maximum employment and moderate long-term interest rates). The current Fed has taken to defining price stability as 2% inflation. Given that the Fed already basically believes it has accomplished the other two objectives, and price inflation has been nothing but rock-solid stable for several years, it’s not clear why it’s still so determined to get inflation up to that 2% target rate, and letting that dictate its monetary policy. If prices are stable at about 1.5%, rather than 2%, doesn’t that meet the mandate, as long as prices are stable?

During the Great Depression of the 1930s the lack of inflation – more accurately, deflation – was a big problem, feeding the downward spiral in the economy for more than ten years. Since then, economists, both on the Fed and elsewhere, have been absolutely terrified of that happening again, even though we haven’t come close to it, not even during the depths of the recent Great Recession. Now that we have seemed to have finally pulled out of the last financial crisis, it’s time to put that deflation obsession to rest.

The Fed’s inflation mandate was mainly put in place to ward off deflation, which we haven’t seen in nearly 100 years, as well as hyperinflation, which we haven’t seen since the stagflation of the 1970s (actually, by the standards of 1920s Weimar Germany, Venezuela today and other places, we’ve never had real hyperinflation in this country).

That being the case, the Fed should now instead come up with some other benchmark to guide monetary policy, such as the Taylor rule or some other level it comes up with. But inflation is certainly not cutting it as a benchmark and doesn’t appear it will be looking ahead.

The internet and technology have changed inflation, in fact, they have largely succeeded in wringing inflation out of the economy. They have done so by not only making us more efficient but by creating an enormous level of transparency, enabling businesses and consumers to find out the lowest price of just about everything within seconds. It’s very hard to raise prices in that kind of environment since buyers will find out right away.

That also makes it harder for workers, unless they have unique skills to offer prospective employers, to demand higher wages, since companies can always find someone with similar skills and experience to do the job for less money.

This is not to say that inflation won’t rear its ugly head in the future for some other reason, like the Fed printing too much money or keeping interest rates too low for too long. The Fed has actually done those two things, but has gotten away with them since the economy has been so weak. But with GDP growth now appearing to have consistently reached 3% or more, and with tax cuts set to kick in next year, which promise to boost economic growth by another percentage point or so, it needs to start normalizing. But by sticking to that 2% inflation benchmark, which forces it to keep interest rates low, it risks creating what it should be trying to avoid, namely too-high inflation.

The Fed has in fact never been able to accurately measure inflation and therefore has no business in trying to target it. First of all, there’s more of it than the Fed acknowledges, and for one very simple and obvious reason. While it measures the level of price changes on various goods and services, it neglects to include the amount of money people spend on taxes, which eat up at least 20% of the average American’s pay. How can you purport to gauge inflation and leave out tax increases? The Fed seems to think that taxes don’t count. (Boy, do I wish that were true).

The Fed should instead come up with some other benchmark to help it set monetary policy, such as GDP growth, bond yields, maybe even the S&P 500 – or some conglomeration of economic statistics. They would likely show that it needs to be more aggressive in normalizing interest rates.

Right now, pegging monetary policy and raising or not raising the federal funds rate depending on whether or not inflation hits 2% and stays there for some given period of time just looks silly and an exercise akin to chasing the white whale.

President Trump has a historic opportunity to change the Fed and its way of doing business. While naming Powell to succeed Yellen wasn’t exactly a radical move, there are several other vacancies at the Fed where he can make a bolder statement and get monetary policy where it needs to be, i.e., back to normal.

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George Yacik
INO.com Contributor - Fed & Interest Rates

Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.