Over the years, I’ve had a number of conversations with commenters that take the following form:
Me: The Fed screwed up by missing its target of X.
Commenter: Yes, but they ended up doing Y, which is the target I prefer in any case. Is Y such a bad target?
Me: No, Y is not such a bad target. But if the Fed has a target of X, then they need to hit X.
Commenter: But what’s wrong with doing Y from now on?
Me: Here’s the problem. If the announced target is X, and then they do Y, they’ll eventually try to push the economy back to X. Alternating between X and Y is worse than doing either policy consistently. Monetary policy instability creates business cycles.
I would add that policy “X” (which in this case is a 2% FAIT policy) was only announced 19 months ago. To abandon the policy so soon would mean an extreme loss of credibility. Why would anyone believe the new policy? But these policy rules are only effective in stabilizing the economy if people do believe them.
I am not arguing that all is lost. The inflation rate has averaged 2% since 1991. (OK, it’s actually 1.995% over the past 31 years, but that’s very close to 2%) That’s a pretty long time. So the Fed’s credibility has not gone to zero. But they have certainly lost some credibility in the past year with 12-month PCE inflation currently running at 5.8%, and expected to remain high.
The Fed’s 2% FAIT is actually a very good policy. As St Louis Fed president Jim Bullard once observed, it’s quite similar to NGDP level targeting. It’s a pity the Fed abandoned the policy so hastily.
PS. In case you are interested, the 20-year inflation rate is 2.04%, and the 10-year inflation rate is 1.86%. The real problem is that the inflation rate during the 2020s is likely to be higher than the Fed’s FAIT would require.
PPS. I just saw a new speech by Chair Powell:
Some have argued that history stacks the odds against achieving a soft landing, and point to the 1994 episode as the only successful soft landing in the postwar period. I believe that the historical record provides some grounds for optimism: Soft, or at least soft-ish, landings have been relatively common in U.S. monetary history. In three episodes—in 1965, 1984, and 1994—the Fed raised the federal funds rate significantly in response to perceived overheating without precipitating a recession.
It’s worth noting that 1965 represents a major Fed policy error, which led directly to the Great Inflation. Policy actions in 1984 and 1994 were indeed successful, but in both cases the inflation rate the Fed was dealing with was significantly lower than inflation had been 5 years previously. Today, inflation is far higher than five years previously, so the Fed’s job is now much more difficult. They can still avoid a recession if they quickly bring NGDP down to 4% and keep it there, but that outcome will be much more difficult to achieve due to their abandonment of FAIT.
READER COMMENTS
Daniel
Mar 21 2022 at 4:16pm
Here’s Powell on 8/27/2020:
When they were targeting 2% every year, deviations from that were clearly mistakes. But they are vague on what “average” and “over time” entail, so it’s a bit difficult to clearly argue they have failed or abandoned this policy.
You look at the trailing 31-year inflation rate (yep, we all agree that counts as “longer-run” or “longer-term” or “over time”), and you see pretty decent success. Imagine in 10 years someone doing the same or looking back over 41 years, what will they see from 2001 to 2032 or 1991 to 2032? Because their policy is so vague, it’s possible that the inflation we’re seeing right now is not definitively a catastrophic policy abandonment; it could be somewhere between that and “slightly off track.”
James A
Mar 21 2022 at 4:42pm
With WW3 beginning, aggressively tightening MonPol seems very risky.
A recession isn’t so bad given real growth in the stagflationary 1970s was better than the deflationary last decade. Inflation allows more relative (real) price changes than deflation – thus boosting productivity and real growth.
Andrew_FL
Mar 21 2022 at 5:59pm
World War III? What are you talking about, there’s nothing global in scale happening
Mark Brophy
Mar 21 2022 at 7:27pm
Ukraine is a puppet government. In reality, the United States is running the show and is at war with Russia, a foolish policy that can easily lead to another world war. Russia is a great country that we should trade with rather than wage war against them. Biden refuses to negotiate a quick end to the war because he intends to bleed Russia as much as possible.
Andrew_FL
Mar 22 2022 at 1:27am
Literally none of that is true
Scott Sumner
Mar 21 2022 at 6:21pm
Daniel, It’s possible that the Fed is not abandoning the policy Powell had in mind all along. But how would we know, as he never told us what that policy was.
And that’s just as bad.
I assumed that average meant average.
But I agree that recent policy has not been “catastrophic”, indeed it isn’t as bad as policy in 2008.
Mark Brophy
Mar 21 2022 at 7:22pm
It’s wrong to claim that the inflation rate has averaged 2% since 1991. In reality, the government constantly changes the definition of the Consumer Price Index so that they can understate “inflation” and reduce pensions and other obligations with adjustments for cost of living. An even bigger problem is that the government doesn’t even try to measure asset inflation, a reverse Robin Hood transfer of wealth to people who own stocks and real estate.
Philo
Mar 22 2022 at 12:00am
You write: “If the announced target is X, and then they do Y, they’ll eventually try to push the economy back to X.” But you can’t count on this. The Fed seldom announces a really clear-cut target–X is usually quite fuzzy–and it frequently tweaks its announcements; as you point out, “policy ‘X’ (which in this case is a 2% FAIT policy) was only announced 19 months ago,” and seems already to have been abandoned (though the “announcement” of this was not perfectly clear). Finally, the Fed seems not to be completely serious about hitting its announced targets, since it frequently predicts that they will not be met.
In short: the “targets” are vague, changing, and not fully serious.
Scott Sumner
Mar 22 2022 at 11:50pm
If so, then I am right for a different reason.
Tacticus
Mar 22 2022 at 7:36am
It’s very concerning that Powell seems to think 1965 is an example of a Fed victory.
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