“Targeting the Fed” by John Edward

John Edward, a resident of Chelmsford who earned his master’s degree at UMass Lowell and who teaches economics at Bentley University and UMass Lowell, contributes the following column

Federal Reserve Chairman Ben Bernanke is often called the second most powerful person in Washington. Federal Reserve monetary policy has a powerful influence on our economy. The central bank Bernanke leads is pretty good at hitting their policy target.

What if the Fed is aiming its powerful ammunition at the wrong target?

Under Bernanke, and for the first time since it was established in 1913, the Federal Reserve now declares an explicit target for inflation. The target is a 2 percent annual increase.

The Fed is responsible for promoting economic growth while making sure inflation does not get out of control. As described in their Mission Statement, the Federal Reserve Bank has a “dual mandate” to pursue “maximum employment” and “stable prices.”

In my last column I talked about a little-known policy of the Federal Reserve. In this column, I will discuss the Fed’s dual mandate and the policy target they shoot for.

The Fed is not very worried about inflation right now. The measure of inflation used by the Fed showed prices increasing by 2.2 percent in 2011. For the 12 months ending in May, the Consumer Price Index was up 1.7 percent. In their most recent policy statement, the Fed said: “The increase in oil and gasoline prices earlier this year is expected to affect inflation only temporarily, and the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.”

Perhaps we would be better off if the Fed worried even less and raised their inflation target to 3 or 4 percent. Alternatively, perhaps they should be targeting something other than inflation.

Harvard economist Kenneth Rogoff established an anti-inflation reputation during his tenure working for the Fed in the 1980s. Professor Rogoff now argues that a temporary shot of inflation would benefit the economy.

Normally, higher inflation would be something to avoid. Normally, proposing even temporary inflation would seem like playing with fire. The economy is anything but normal right now.

We are still feeling the pain caused by the financial crisis. A weak recovery is constrained by a depressed housing market, high personal debt, a large national debt, and general pessimism.

The front-page coverage of the May jobs report described the employment situation as dismal. The official unemployment rate has been over 8 percent for forty months in a row. That does not count almost 2.5 million people out of work but not counted as unemployed. That does not count over 8 million people working part time because they cannot find full-time work. The economy grew by only 1.7 percent in 2011.

In response to the financial crisis, the Federal Reserve played its role of “lender of last resort” to unprecedented levels. The government, with the Fed’s help, rescued financial institutions that were too big to fail.

Now, many large banks are doing very well in an environment of historically low interest rates. According to the Federal Deposit Insurance Corporation, bank profits were up 40 percent in 2011 to $120 billion. Banks are off to a good start in 2012 – profits were $35 billion in the first quarter.

Yet, banks are hesitant to lend. They are reluctant to renegotiate loans issued before the crisis when rates were much higher. Meanwhile the Fed, in a strategy designed to control inflation, is paying banks not to lend.

Moderate increases in prices and wages would help the economy. Borrowers burdened by debt would find it easier to repay their loans and start spending again. Professor Rogoff argues that a moderate dose of inflation would increase consumption, increase investment, and revive the housing market.

No one is suggesting we return to the double-digit inflation caused by the energy crisis in the 1970s. Professor Rogoff contends we should be more worried about repeating the 1930s than the 1970s.

Bentley University economist Scott Sumner writes a very popular blog on monetary policy. Noble Prize winner and New York Times columnist Paul Krugman has cited, and in some cases opposed, his views.

Professor Sumner has offered a very detailed case for changing the Fed’s target. He observes the political obstacles to allowing higher inflation. He them makes the economic case for moving the target off inflation.

He proposes making Nominal Gross Domestic Product the target of Fed policy. Nominal GDP includes both real growth and inflation. He makes a compelling case that targeting Nominal GDP would give the Fed more flexibility in responding to crises like the one that still burdens us. It would be easier for the Fed to pursue their dual mandate.

Professor Sumner readily admits his approach would temporarily lead to higher inflation. However, as he observes:
Americans view inflation as a process that reduces their living standards… Inflation is thus highly unpopular. Yet according to standard macroeconomics, only-supply-side inflation (caused by shortages or other supply shocks) reduces living standards; inflation generated by the Fed actually raises living standards.

(Go here if you want to read the entire National Affairs essay.)

There is, of course, a risk that once prices start going up the Fed might find it challenging to control inflation. However, with the situation as it is now we may face a greater risk of deflation – falling prices and wages. Deflation can be very damaging to the economy and more difficult to fix than inflation.

Inflation has been under control for three decades. Moderately higher inflation for a year or two should be manageable. Moderately higher inflation will not hurt the economy, in particular if it is expected. When people expect a certain rate of inflation, they can plan accordingly.

Perhaps I was asking for too much when I suggested we Bend the Fed to target inequality. For now, I would settle for more flexibility