On August 27, Federal Reserve chair Jerome Powell revealed results of a reappraisal of monetary-policy implementation that he initiated in 2018. The “framework” review dealt with long-term policy beyond the current crisis. In Powell’s words, “To an extent, these revisions reflect the way we have been conducting policy in recent years.” The marginal changes may be marginal improvements but leave unresolved the fundamental dilemma of Fed policy: the central bank’s inability to attain its 2 percent inflation target.
The Fed highlighted three new policy adjustments. The first acknowledges impediments to executing monetary policy with low interest rates. The Fed must move more quickly in adjusting its policy rates. Ironically, the Fed is in large measure responsible for low interest rates. Former Fed Chair Ben Bernanke found, prior to the current crisis, that the Fed’s quantitative easing suppressed market interest rates by 1.20 percent.
For the second adjustment, the Fed will “[seek] to achieve inflation that averages 2 percent over time.” Is there a distinction between that statement and the Fed’s previous position of a “symmetrical” 2 percent target? Let the author know if you see one.
For the third of the framework adjustments, the Fed will maintain low rates, even with low unemployment, as long as inflation remains around 2 percent. This finally retires the defunct Phillips curve, a 60-year-old observation that low unemployment causes high inflation and vice versa. While unemployment is correlated with employee compensation, there is no long-term carryover to general prices. The Phillips curve was first discredited by the 1970s stagflation, with its high unemployment and high inflation, but somehow hung on at the Fed until this decade’s low unemployment and low inflation. The curve led the Fed astray in 2018, as it tightened with declining unemployment while inflation flatlined.
The Fed hopes that the new framework, by convincing the public the Fed really means to reach its target, will be self-fulfilling. The problem is, the Fed really meant it when Bernanke initiated the concept of a 2 percent target in 2003, when it officially adopted the 2 percent target in 2012, when it spent the equivalent of 20 percent of the U.S. economy for QE, and when it held interest rates below normal for a decade. Despite clear intent, the Fed has repeatedly failed.
The Fed didn’t fail for lack of ability. Anyone meeting its representatives and leaders cannot but be impressed by their knowledge, education, and intelligence. No sentient human being could doubt their commitment to reaching 2 percent. It’s just that they can’t.
The Fed has plenty of company. Comparably capable people at central banks throughout the world are failing too. After the Bank of Japan spent over 100 percent of its gross domestic product and held interest rates below normal for 25 years, even to negative levels, can anyone doubt its resolve? Forty percent of GDP spent, below normal interest rates for twelve years, zero or negative rates for eight years — is the European Central Bank’s determination in question?
The evolution of the monetary system in advanced economies has passed by central bankers’ targets and frameworks. Currently, monetary stimulus in major advanced economies has little to no effect on long-term economic activity and inflation, serving primarily to inflate asset prices.
The Great Inflation, with its shocking double-digit inflation and interest rates, left its mark. Along with the subsequent Volcker disinflation, the direct impact of central banks on inflation seemed clear. In recent history, however, massive, extreme, and unparalleled central-bank actions have had no discernible effect on long-term inflation. How to explain this dichotomy? As with so many other economic factors, monetary stimulus is subject to diminishing effects.
Chart 1 examines inflation compared with Fed monetary stimulus. Instead of viewing inflation as a change in prices, the chart measures inflation by changes in the historical value of a dollar in today’s terms, adjusted by the Fed’s preferred price index, core personal consumption expenditures (PCE), excluding food and energy.
The chart begins in 1951 with the dollar worth $7.54 in today’s terms. Fourteen years later, in 1965, the dollar had fallen to $6.13. Another 15 years later, in 1980 during the Great Inflation, feckless Fed leadership let the dollar plummet to just $2.66. To this point, small changes in Fed assets produced large changes in prices and inflation.
Around 1995, the responsiveness of prices to monetary stimulus changed. Massive Fed asset growth from quantitative easing produced little price movement, leaving today’s low inflation. This same relationship between monetary aggregates and the value of a currency (a hyperbola, for those who remember geometry) applies to other advanced economies and to other monetary measures such as M2 money supply. Diminishing effects don’t mean inflation is impossible; it just becomes very difficult, as the world’s major central banks can attest.
So, with diminishing inflation-responsiveness, how does the Fed clear its 2 percent goal? Chart 2 depicts the path of inflation since 1996, including 2004–07, when core PCE inflation ran above 2 percent.
In chart 2, inflation is compared with the foreign-exchange value of the U.S. dollar. Changes in the dollar’s value are inverted hence a weaker dollar moves with higher inflation — the usual relationship as evidenced in the chart. With unresponsive inflation as depicted in chart 1, changes in the dollar’s foreign-exchange value are the major short-term influence on prices. It took a 37 percent depreciation of the dollar from early 2002 to mid-2008 to provoke the only sustained inflation over 2 percent in the last 25 years. That dollar weakness arose from loose monetary policy, which enabled massive debt expansion.
Chart 3 depicts inflation versus growth in banking-system assets, through which monetary policy is transmitted.
When inflation above 2 percent prevailed in the mid-2000s, bank-asset growth averaged in double digits. This was the run-up to the Great Financial Crisis.
The financial crisis frequently is attributed to growth of non-bank “shadow” finance, but regular bank assets grew more quickly. From the inflation bottom early in 2002 to just before the October 2008 crash, bank assets grew 80 percent compared with 68 percent for total private U.S. debt. Shadow banks depend on regular banks for financing and services, and the mid-2000s surge of bank assets instigated the financial crisis.
It seems odd that such a small change in inflation is associated with the financial cataclysm, but chart 1 highlights how, when inflation is unresponsive, only extremely large monetary changes affect it. The banking system is much stronger now, but any comparable debt build-up will produce a crisis whether in banks or elsewhere in the economy.
On top of the risk of whether the Fed meets its target, there is risk in its pursuit. To spur 2 percent inflation, the Fed must maintain interest rates below normal for an extended period — as long as 20 years, in one Fed study. The Fed desires higher inflation so it has more latitude to cut interest rates in a downturn, but the contradiction of lowering rates more than higher inflation can boost them is exemplified by the coronavirus crisis. To gain 0.25 percent of inflation the Fed maintained interest rates 1.00 percent below normal, thus hampering its crisis response.
The Fed has sophisticated models underlying its 2 percent goal, but it must look at reality too. The prestigious Bank for International Settlements, the central bank for central bankers, has found that for OECD countries “there is a significant negative correlation between inflation and income growth during rather long periods.”
Between the Great Financial Crisis and the current one, the U.S. was growing above what most economists believe is its long-term potential. Inflation averaged 1.6 percent. That performance is as good as can be, given ongoing U.S. stagnation. The Fed’s framework was not the problem. The 20-year-old target is unlikely to be reached consistently and should change to reflect today’s U.S. economy. Stubborn persistence at 2 percent threatens America’s purchasing power and financial stability. Since the coronavirus crisis, the U.S. dollar has fallen 7 percent. Bank assets have grown 10 percent over last year, the fastest rate since the Great Financial Crisis. Both movements are likely short-term effects of the current crisis, but they bear watching for potential negative long-term impact.