Karl Smith makes the case that the Fed should let the economy run hot. It should hold off on raising interest rates, even if its restraint causes an increase in inflation. That looser-money policy would have the beneficial effect of boosting employment and wages. It would also train markets to expect that periods in which inflation falls below the Fed’s target of 2 percent inflation will be followed by periods in which it exceeds it. So the next recession will be moderated by expectations of higher inflation to follow it.
Last year Lawrence Summers made a similar argument, suggesting that the Fed should let inflation run above target during a boom “with the expectation that inflation will decline during the next recession.”
I’m agnostic on whether the Fed should be pursuing a modestly tighter or looser policy at the present moment. It’s much more important, in my view, that whatever short-term policy it adopts be part of a shift toward a long-term policy based on commitment to a sound rule.
But the right rule—one that kept the growth of spending throughout the economy steady—would differ from what Smith is recommending in two ways. First, it would not attempt to boost employment, wages, or economic growth, but rather to provide a context of monetary stability. Second, it would yield lower inflation during booms and higher inflation during busts, the opposite of the Smith/Summers suggestion. If the Fed kept spending rising at 4 percent, inflation would hit 1.5 percent while the economy grew 2.5 percent and 4 percent during a no-growth year. Inflation would in other words be counter-cyclical.
In a sense, both of these differences are really one difference. What I’m saying is that the Fed’s proper role is not to make the economy run alternately hot and cold but, so far as possible, to avoid doing that.