The Fed’s inflation-targeting framework has forced monetary policy to be too tight for the better part of a decade.
President Donald Trump has the monetary-policy blues. The Federal Reserve’s four interest-rate hikes in 2018 apparently have him deeply worried that this tightening of monetary policy has weakened the economy. Hence in recent months, Trump has become an outspoken critic of the Fed.
The president’s instincts that something is wrong with Fed policy are actually on point, but he is just scratching the surface of a much deeper problem. The Fed’s current inflation-targeting framework has effectively forced monetary policy to be too tight not just during Trump’s presidency but for the better part of a decade.
Look first at the Fed’s failure to hit its own inflation target of 2 percent. The Fed officially began inflation targeting in 2012 but has been implicitly targeting 2 percent for several decades. The Fed’s preferred measure of inflation, however, has averaged about 1.5 percent since 2009. The persistence of below-target inflation means the price level has drifted far below where it was expected to be a decade ago.
Another measure of monetary policy, total dollar spending in the economy (or nominal GDP), tells an even grimmer story. This measure reveals that the Fed has effectively dialed back the growth of money spent over the past decade. Figure 1 shows that total dollar expenditures annually grew on average 5.6 percent in the period leading up to Great Recession. Since 2009, it has averaged only 3.6 percent per year.
Figure 1 also includes a forecast that suggests total dollar spending would have bounced back if the Fed had permitted it to, making up for the shortfall after the financial crisis. But alas, this makeup for past mistakes was not allowed.
By the inflation and nominal-GDP measures, then, the Fed has been too tight since 2009. President Trump’s monetary-policy blues are just a recent symptom of this tightness.
What explains this decade-long phenomenon is that the Fed has become a victim of its own success. Over time, the Fed has built up its inflation-fighting credibility, which, like a governor placed on a truck’s engine to control its speed, creates a powerful speed limit for the economy. That is, if the public expects the Fed to be vigilant in managing inflation, then inflation is unlikely to arise in the first place. Normally, this is a welcome development. There are occasions, however, when a speed limit on the economy can backfire.
First, just as a truck driver may need to temporarily drive faster to make up for lost time after being stuck in traffic, an economy may need to temporarily speed up to get back to its full potential after a recession. Though the speeds of the truck and economy are briefly higher than normal, their average speeds over the entire journey are no different than if there had been no slowdown. Such periods of acceleration, however, can never happen if there is a rigid adherence to the speed limit. The Fed’s inflation-fighting credibility has created such a speed limit for the economy.
Second, a governor installed inappropriately on a truck’s engine can cause it to drive too slow even in normal times. Likewise, the Fed’s inflation-fighting credibility, if too strong, can push the economy’s normal speed below what is needed for a healthy economy. That appears to be the case over the past decade, as evidenced by the relatively large decline in the average growth rate of total dollar spending since 2009. The Fed’s inflation-fighting credibility, in short, has created an artificially low speed limit for the economy.
This rigid and artificially low speed limit on the economy was a key contributor to the weak recovery after the Great Recession — and perhaps some of the political turmoil that has followed. It is also at the heart of President’s Trump monetary-policy blues and demonstrates why there can actually be too much inflation-fighting credibility.
Fortunately, there is a fix for this problem that eases up on the rigidity and level of the economy’s speed limit without losing the Fed’s inflation-fighting credibility. The solution is for the Fed to target the growth path of total dollar spending rather than target the inflation rate.
Such a target, commonly called a nominal-GDP target, allows more flexibility for inflation in the short run while still anchoring it the long run. It also requires the Fed to make up for past misses of total dollar spending from its targeted value. Together, these features would ease the rigidity of the current speed limit on the economy while also making it easier to the set it at the right level. Finally, asset prices closely track the outlook for total dollar spending. That means the Fed could more readily use market signals to help set monetary policy.
A nominal-GDP target would make life easier for the Fed, allow capitalism to flourish, and help President Trump end his monetary-policy blues. Fortunately, the Fed is reviewing its approach to monetary policy this year. Hopefully, it will take a close look at it and consider adopting this alternative monetary-policy framework. The world would be a better place if it did.