Why the Fed should hit its target
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.