Because the Federal Reserve’s most important job is to conduct monetary policy in a way that promotes stability, it has a salutary bias toward caution. But that caution has served it badly in its recent review of its policies. It knows it needs to change, but what it is willing to do falls short of what is needed.
The signs that its current approach is not working have been proliferating. In 2012, the central bank announced a target inflation rate of 2 percent; it has spent almost all of the time since then with inflation well below that target, raising questions about its credibility. The long secular decline in interest rates has left the Fed with little ability to use its principal tool for combatting recessions, which is further declines in interest rates. (We are seeing that limitation now, after having taken a big hit from a pandemic that began a year after the Fed’s review started.) Low interest rates and quantitative easing have not increased inflation, or production, as much as many observers had expected. And the Fed has admitted that its earlier model of how low unemployment could safely go was mistaken, causing it to raise interest rates too quickly and thus keep employment and wages from growing as robustly as they could have.
After a long review, the Fed has decided to respond to these challenges by switching from a 2 percent inflation target to . . . a 2 percent average inflation target. It has also said that it will not raise interest rates in order to keep unemployment from falling too low. That second step is a positive development, but the first step is an ambiguous one. In theory, a policy of allowing 2.5 percent inflation after a year of 1.5 percent inflation, or vice versa, will make the price level more predictable over the long run. And by lowering the likelihood of a persistent shortfall, it will boost the effectiveness of anti-recessionary policies. But there is a risk. If inflation runs under target inflation during a downturn and then above it during a boom, all the Fed has done is make the economy’s swings more pronounced — which is the opposite of what it’s supposed to be doing.
If it chose another course, the Fed could minimize that danger while also doing more to enhance its ability to fight recessions. Targeting spending throughout the economy, so that it grows at a steady 4 percent rate, would allow inflation to go up and down in response to trends in productivity while sticking to the 2 percent average. It would generate lower inflation during a boom, which is when it’s most desirable. The Fed should also abandon its post-2008 policy of paying banks interest on excess reserves, which has unduly complicated its ability to hit any target. (It’s one reason there has had to be so much quantitative easing for so little payoff: Banks have been discouraged from lending out the new money.)
There are gradual ways of implementing such changes, if the Fed wanted to make them. We fear that it will have ample time to consider the matter during the sluggish recovery its current approach will produce.