The Federal Reserve policy review should embrace a hard ceiling for inflation

The Federal Reserve will soon begin its quinquennial review of the monetary policy strategy, tools and communications employed to fulfill its Congressional mandate—price stability, maximum employment and moderate interest rates.

Price stability should mean 0% inflation—some prices fall, others rise, but overall, the value of money is unchanged. Even if achievable, that would retard growth and suppress employment.

Businesses would be reluctant to invest because, during periods of slack demand or recessions, falling prices would make it overly burdensome to service the debt necessary to expand enterprises and establish new ones.

Setting the target too high would encourage businesses and households to overspend—buying a new truck or car sooner than needed because they expect it to cost more.

According to former Fed Chair Alan Greenspan: “Price stability is that state in which expected changes in the general price level do not effectively alter business or household decisions.”

Nothing is magical about the 2% goal the Fed and other major Western central banks adhere to. Rather, it evolved from a goal offhandedly embraced by the Reserve Bank of New Zealand in 1989 that became the consensus among central bankers.

After the Global Financial Crisis, central banks kept interest rates in the United States, Europe and elsewhere quite low—sometimes negative for short-term rates—as policymakers struggled to boost inflation to 2%.

The progressive wing of the economics profession—notable figures like Nobel Laureate Joseph Stiglitz and Jason Furman, now a Harvard professor openly questioned whether slavish adherence to a 2% ceiling was prudent and whether much more expansionary monetary policies were in order.

In 2020, the Fed announced it would accept periods with inflation above 2% to compensate for periods below that mark—targeting a 2% average.

Unfortunately, the Federal Reserve has announced that its policy review will not focus on that target but instead emphasize its communications tools.

It has denied or at least ignored its culpability in instigating and extending the post-COVID inflation.

However, the Fed printed about $4.8 trillion in new money to support COVID-19 relief and absorb the excess supply of bonds created by Presidents Trump’s and Biden’s overspending on COVID-19 relief to households and businesses, Chips and Science Act and Inflation Reduction Act electric vehicle and green energy industrial policies. Those took the deficit from 4.6% of GDP in 2019 to 6.1% this year.

As inflation heated up, the Fed delayed raising rates and sought to rely on skillful communications to manage expectations. First, we were told shortages and supply constraints were the culprits and then a soft landing was possible—inflation would return to 2% without a recession.

Expectations became unmoored.

Inflation has moderated to 2.7%, largely owing to lethargic economic conditions in Europe. Germany and France are in unending political crises, with weak coalition governments, overregulation and a generation of underinvestment, leaving the continent unprepared to compete with American businesses in the technology industries and Chinese enterprises in the EVs, batteries and green energy industries.

A real estate bubble severely hampers domestic demand in China, and Beijing encourages manufacturers to push exports to the world at very low prices.

Weak demand in China and Europe is suppressing prices for most goods and petroleum.

That combination has resulted in very low inflation for manufactured goods and petroleum, largely dictated by international conditions beyond the control of U.S. policymakers.

Service prices—restaurants, plumbers and so forth—are rising 4.5%. Those are primarily determined by domestic forces—the availability and quality of labor are key—and workers’ expectations about future inflation.

The New York Federal Reserve Bank, Conference Board and University of Michigan surveys of household and consumer expectations for one-year inflation average is 3.6%.

Moreover, investors don’t buy the Fed’s assurances either—since mid-September, the Fed has lowered the federal funds rate 1% but the 10-year Treasury rate, which provides a benchmark for mortgages and long-term corporate borrowing, has gone up 1%.

That is not a Trump effect—those were rising during the recent presidential campaign whether Vice President Kamala Harris or the president-elect was doing well in the polls.

Fed policy mirrored actions in Europe and Australia, but the scrappy RBNZ increased rates sooner and more than its peers. New Zealand suffered a recession, but inflation is down to 2.1%, and the central bank is aggressively normalizing interest rates.

An IMF study of 100 experiences across 56 countries indicates that decisive and enduring action is needed to curb inflation and that longer-term growth and incomes are better served even if a recession is suffered.

The Fed would do well to reconsider its reliance on talk therapy for the economy. Returning to a hard target would better serve its mandate to support enduring prosperity. It would also commit with clarity not to again enable profligate fiscal policies by running the printing presses.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.