Price Stability Law of 2022, a bill submitted to the House Financial Services Committee would turn the Federal Reserve’s dual mandate into a single mandate. Instead of maximum employment and stable prices, the Fed will seek only stable prices. Is this a welcome change? By not approving or condemning a bill, we can examine its costs and benefits.
The bill does not specify what is meant by “stable prices”. For now, we can interpret it as an inflation target. Whether the actual number is 2 percent or 0 percent, there is not much difference. As long as price spikes are small and predictable, many different targets can work.
While the Fed currently has an “average” inflation target of 2 percent, it has chosen itself and therefore cannot commit itself. The Fed is essentially a judge in its own right. “We did our own investigation and decided we did nothing wrong,” they might say. The imposition of an inflation target by Congress on the Fed could have serious consequences.
A binding outcome target is better than the unverifiable pseudo-target that the Fed currently has. According to the Fed’s own interpretation, the target is asymmetric: they are happy with inflation above 2% but not below 2%. The markets are rightly questioning the Fed’s credibilitywhich affects its ability to conduct monetary policy.
Creating a predictable growth path for the value of the dollar has certain economic benefits. Most economists think of “forward-looking leadership” (central banks communicate their intentions for future policy) in terms of interest rates. It is not right. Interest rates are the prices of capital, and therefore of time. Central banks should not mess with them. On the other hand, price level forecasting is very useful. It creates a solid foundation for economic activity by giving commerce the yardstick. No one could prepare effectively for a race if the definition of the meter was constantly changing. A similar truth is true for economic activity. The unpredictability of the price level can lead to short-term underproduction or overproduction and long-term underinvestment. In contrast, a robust push for growth in the purchasing power of the dollar creates a solid foundation for markets to provide full employment today and could have a beneficial effect on growth tomorrow.
But the inflation target has some disadvantages. Imagine we are facing a massive performance hit that makes turning input into output more difficult than expected. This is an example of what economists call a negative supply shock. Economy-wide prices will rise, which means that the purchasing power of the dollar will fall.
Supply problems create inflation. An inflation-focused Fed will be forced to cut overall spending (aggregate demand) in order to bring inflation down again. But this means that real output and employment, already hit by the supply shock, will take a second hit. The central bank will hit its inflation target by worsening the economic downturn.
A Fed mandate focused on rising nominal spending rather than inflation could have avoided this problem. Aggregate demand means nominal GDP: output valued at current market prices. In the event of a supply shock, the spending-driven Fed would not need to cut aggregate demand to bring down inflation. On the contrary, it would allow inflation to offset some of the damage from slowing productivity. Output and employment will continue to fall. Difficulties on the supply side make this inevitable. But the Fed won’t compound the damage. In fact, the spending target looks pretty close to a first-best policy. An increase in the scarcity of goods relative to money means that the price of money must fall. Inflation in this case shows an excess of money compared to goods. It does not have any independent negative welfare implications.
The spending growth target also tends to ensure long-term price stability. Supply shocks are usually temporary. When performance issues are resolved and output returns to trend, so do prices. Therefore, the goal of spending growth can also be justified by the demand for price stability alone.
The inflation target is not as good as the spending target. But this does not mean that the goal of inflation is undesirable. We rarely choose the best policy. Perhaps second best is all we can hope for, given the limitations of the political system. Given the choice between an inflation target and nothing, there are good reasons to prefer an inflation target. We need to get the Fed to comply results based rules. Monetary policy discretion works poorly and is also difficult to reconcile with the rule of law.
Politics is a compromise. Half a loaf is better than none at all. Price stability is half the rules of monetary policy. It is foolish to starve just because haute cuisine is not available.