The Fed Thinks Higher Prices Are Good For You

The Federal Reserve Board’s quantitative easing program was an unprecedented monetary experiment that dumped trillions of dollars of new money into the economy.

Historically, adding that much money to the economy should have caused hyperinflation, but the economy was so weak, it took the Federal Reserve Board eight years of loose monetary policy to boost the U.S. inflation rate to 2%.

Now, though, some Fed members think that 2% isn’t enough.

Readers old enough to vote during the Carter and Ford years remember when the Fed’s role was to lower inflation, not raise it. In 1974, inflation hit 11.03%, and from 1979 through 1981 inflation reached 11.22%, 13.58% and 10.35%. In the Ford era, Whip Inflation Now (WIN) buttons were created. They did little to control rising prices.

We haven’t seen any Boost Inflation Now buttons, fortunately, but helping the economy by increasing inflation is the dumbest idea since negative interest rates. Given the Fed’s recent history, that may be its appeal.

Why the Fed Shouldn’t Boost Inflation

The first sign that higher inflation is a bad idea is that it came from an economist. According to The Wall Street Journal, “Olivier Blanchard, an economist at Peterson Institute for International Economics, kicked off the debate over higher inflation in 2010 when he suggested a 4% target while serving as the International Monetary Fund’s chief economist. The idea was that a steady rate of higher inflation would mean that nominal interest rates could be higher too, leaving central banks more room to cut in a downturn to boost output.”

In other words, we should wreck the economy to make it easier to fix. But there are plenty of other reasons why the Fed shouldn’t seek a higher inflation rate:

Consumer income still hasn’t recovered. With the economy improving and unemployment down, consumer income is increasing, adding to consumer confidence.

But consumer income is still below pre-financial crisis levels. Boosting inflation would be equivalent to giving everyone a pay cut, resulting in less discretionary income and less spending. Consumer confidence would drop and economic growth would potentially slow down.

Production costs would increase. A National Association of Manufacturers survey showed that optimism among members is at a 20-year high, while the Institute for Supply Management’s index was at 57.2 in March (anything over 50 indicates growth). That’s down slightly from February, when it reached 57.7 – its highest level since August 2014.

Higher inflation would enable businesses to charge more, potentially boosting corporate profits. But they would also be paying more, as the cost of raw materials and other goods would increase, which could stifle growth just as the sector is recovering.

Inflation is likely to increase without the Fed’s meddling. Inflation often increases rapidly. It’s slightly more than 2% now and if the economy continues to improve, it will likely continue to rise, even without adding a penny to the money supply.

President Trump’s trade policies could likewise boost inflation. Tariffs on imports would not only increase prices, they would eliminate pressure on American manufacturers to keep prices low.

The target rate is arbitrary. The 2% target adapted by the Fed has always seemed arbitrary. Why 2%? Why not 1%, which would avoid deflation while minimizing the impact of rising prices? Or 3%? Or, since the Fed likes to appear as though it’s really thought about what it’s doing, 2.793%?

Just because a stronger economy results in higher inflation doesn’t mean that higher inflation results in a stronger economy.

There’s no logical explanation for raising the target rate. According to new research by Fed economists Michael Kiley and John Roberts, today’s low natural interest rate “suggests Fed officials may now confront near-zero interest rates 40% of the time or more because of the low natural rate.”

The natural rate is the same as the neutral rate of interest, which the Fed has been talking about a lot lately. The Brookings Institution, which published the study, notes that the natural rate is “a theoretical construct.” It is the interest rate “that will prevail when the economy is at full employment and inflation is stable at a central bank’s target. When a central bank sets interest rates below that level, monetary policy is stimulating the economy; when the rate is above that level, it is doing the opposite.”

The Brookings study notes that near-zero interest rates constrain monetary policy, because it’s difficult to drop rates when they are already near zero. As a result, it’s more difficult for the Fed to achieve its 2% inflation objective and reach full employment.

“The authors’ analysis suggests that a monetary policy that tolerates inflation in good times near 3% percent, above its 2% percent long-run inflation target, may be necessary to bring inflation to 2% on average,” the research says.

So 3% inflation in good times is meant to compensate for 1% inflation in bad times. But why do we want inflation to be 2% “on average?”

It sounds as though the researchers are suggesting that the Fed move its inflation target to whatever level of inflation the economy is producing, rather than trying to move the inflation level to 2% with the expectation that 2% is the optimal level for the economy.

That almost makes sense. It would make even more sense for the Fed to not have a target rate of inflation at all.

The Fed researchers use “a dynamic-stochastic-general-equilibrium (DSGE) model and large-scale econometric model, the FRB/US model” to reach their conclusion, but they would have been better off relying on common sense.

No one really knows what the rate of inflation really is. As we recently noted, Martin Feldstein, chairman of the Council of Economic Advisers under President Ronald Reagan, wrote in The Wall Street Journal that it’s nearly impossible to measure the true rate of inflation.

Because of the rapid pace of technological change, today’s products are much different than the products of even a year or two ago. How do you compare today’s smartphone with your previous cellphone? And if you can’t compare the two products, how can you determine how much prices have changed?

“The problem that consumers care about and that should be the subject of Fed policy is avoiding a return to the rapidly rising inflation that took measured inflation from less than 2% in 1965 to 5% in 1970 and to more than 12% in 1980,” Feldstein wrote.

We couldn’t agree more. Let the Fed worry about the natural rate of interest, but, for the sake of the economy, we’d like to see the Fed allow a natural rate of inflation.

If you enjoyed this post, please consider leaving a comment or subscribing to the RSS feed to have future articles delivered to your feed reader.

Tags: , , , , ,

Comments are closed.